This is a guest post from Stock Pair Trading, creator of the website StockPairTrader.net. This was originally posted at The edge of pair trading, profitability of the strategy and is republished here with permission.
We explained in our previous article that today, stock pairs constitute an integral part of the trading strategy of all professional traders, banks, and investment funds. That strategies use different ways to identify trading opportunities by monitoring the difference in the prices of two stock titles. We have also shown that we do not need to know the direction in which the market will go in order to achieve a profit. We already know that stock pairs are a market-neutral strategy and that we have a myriad of stock titles for trading. Stock pair trading can be easily automated using specialized software.
The edge of stock pairs
Long-term profitability is based on three pillars: 1) limited risk of loss, 2) speculation on the return of the ratio of prices to its long-time average, without the influence of external factors, 3) broad portfolio diversification thanks to the ample trading opportunities.
Risk management – mitigating the risk of loss
As we have already explained in a previous article in our series, the foundation of a trader’s sustained success on stock markets is risk management = limiting the maximum potential loss to an acceptable level. Whereas a simple Long / Short position may sustain a theoretically unlimited fatal loss, a pair position is protected from this risk, by its very nature. Thanks to the simultaneous opening of an identical (in terms of dollar value) Long and Short position, the risk of loss due to a sudden sway in the market is fully eliminated. If, for example, the entire market dropped due to adverse fundamental news, the profit from the short position would cover the loss from the long position. The total profit will therefore remain close to zero in spite of the whole market having sustained a significant loss. Thanks to that, a trader may continue to trade and accumulate a profit. Remember: Risk management is the most important part of every investment strategy.
Speculating on a return of the price ratio to its long-term average
Most traders agree that it is difficult (or even impossible) to predict the price of a single stock title. But there is evidence that the it is possible to predict the behavior of a group of shares (in our case a stock pair). How is that possible?
Portfolio diversification
No trading strategy generates solely profits. Loss is an integral part of stock trading and stock pairs are no exception. A loss occurs when the difference between prices does not revert to normal within the set time. Rules for leaving a position must be set to deal with this adverse development. The simplest and at the same time very effective method is a time stop-loss – the closing of a position no later than at the end of a day defined in advance.
