Pairs Trading for Stock Index

Pairs Trading for Stock Index

What is Pairs Trading?

Market neutral or pairs trading is a strategy to achieve profits through simple and relatively low-risk positions. Since the pairs trade is market neutral, the direction of the overall market will not affect its win or loss.

It is one of the most popular strategies employed by hedge funds, and remained a secret of the pros until the advent of the internet.

Today, we will discuss on the trading approach in order to successfully implement pairs trading.

How to successfully implement Pairs trading?

We will focus on the stock markets in Germany, France and UK as they represent the stock indices, namely Germany’s DAX 30, French’s CAC 40 and the UK’s FTSE 100.

There are reasons why we would choose to focus on the DAX, CAC and FTSE indices.

It is because:

1. They are the world’s top 10 largest economies.
2. They also represent Europe’s three largest economies.
3. There are large daily trading volumes.
4. There are many traders from all over the world.
5. Low trading commission.
6. Less pip spread.
7. Reasonable margin requirements.
8. Daily individual analysis by many experts.
9. Daily news and reporting from well-known media channels.
10. Almost unanimously conform to the European trading hours.

Compare charts – Daily

We will compare the daily charts for all three indices of Germany, France and UK. In the comparison, it is noticed that whenever there is a rise in a country’s stock index, the other two indices will rise rhythmically. Similarly when there is a fall in any country’s stock index, the other two indices will have a synchronised decline. However, there would be few exceptions.

Compare charts – Hourly

If you look at the daily chart, you will notice that there are occasions where the movement of the individual index does not synchronize with the other two indices. Though, eventually the synchronization will occur. This is an interesting phenomenon and the reason to implement the pairs trading method.

Hourly chart plus ROC

What is ROC you might ask? ROC stands for Rate of Change which is a very common indicator. We will study the individual chart for each index with a ROC period of 5.

• Germany DAX30 Single Chart

• France CAC40 Single Chart

• UK FTSE100 Single Chart

Data obtained

From the above single charts, we can obtain the data as below:

In accordance with the data obtained, we can list the indices as follows:

The highest is Germany DAX30 ROC = -0.1898

The lowest is United Kingdom FTSE100 ROC = -0.3896

The gap between -0.1898 minus -0.3896 = 0.1998

However, the ideal gap between the highest and lowest value is 0.4 points or more.

Trading decision

Long position –  United Kingdom FTSE100

Short position – Germany DAX30

From the analysis above, a pairs trade can be performed which will remove market risk. By taking a simultaneous long and short position, a pairs trader is only concerned with the relative performance of the trade. This strategy will enable the trader to use the intimate knowledge of a sector and maximise profit by selling the overperforming stock (known as a put) and buying the underperforming stock (known as call). As the two underlying positions revert to their mean again, the options become worthless and allows the trader to pocket the proceeds from one or both of the positions.