Choosing Long and Short Legs in a Mean-Reverting Equity Pair
Summary
This discussion explains the basic direction of a pair trade when two stocks diverge from a relationship assumed to persist. Under that assumption, the trader shorts the stock judged relatively overpriced and goes long the one judged relatively underpriced. The accepted answer describes possible divergence outcomes: the shorted stock can fall, the long stock can rise, or both can move favorably, so the trader need not identify which leg causes the convergence.
The exchange also points toward cointegration as relevant background and cautions that finding viable pairs and making the strategy work in practice can be difficult. It does not provide entry thresholds, hedge ratios, statistical tests, transaction-cost analysis, or backtest evidence. The direction rule depends on a defensible relative-value relationship; comparing nominal share prices by itself does not establish that one stock is overpriced or that the spread will converge.
Key ideas
- A basic pair trade shorts the asset considered relatively rich and buys the asset considered relatively cheap.
- The trade can benefit if the short leg falls, the long leg rises, or both occur as the pair converges.
- A persistent relationship between the assets is an assumption that needs support, for example through cointegration analysis.
- The discussion offers no implementation rules or evidence that a particular pair will be profitable.
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Full text
# Stat Arb Equity Pair Position Trigger # Stat Arb Equity Pair Position Trigger I am new to pairs trading and am in the process of constructing the code for backtesting a basic pair trading strategy. While I understand the basic idea behind the pair trading strategy, I am having trouble understanding which stock to short or long should future price dynamics change between the pair. My question: Let say stock A currently trades at a price that is more expensive than Stock B. If this relationship continues to persist, whenever there is a divergence in price, I will short A and long B. But if price dynamics change such that price of B > price of A, I would need to switch between the entry such that when there is a divergence, I will need to now short B and long A. Is this correct? ## Answer by Theja Tulabandhula (score 2, accepted) https://quant.stackexchange.com/a/9032 Yes you are correct. If price of A > B, then short A and long B. When prices of A and B diverge: - (a) because of A: Make money since A is (by pairs trading assumption) over priced and we shorted. - (b) because of B: Make money since B is (again, by pairs trading assumption) under priced and we were long. - (c) Because of both A and B: Both A was overpriced and B was under priced is a combination of the above two cases and we make money. These three cases exhaust the scenario that the prices diverged. We do not need to know which of the cases happened to make money. For more information, see http://en.wikipedia.org/wiki/Pairs_trade ## Answer by H. Arponen (score 2) https://quant.stackexchange.com/a/9012 Please see e.g. wikipedia entry for cointegration. You should also probably read the original paper here and/or the book by Vidyamurtha. Vidyamurtha's book is a bit messy, but IMO quite OK. Also, I think it's going to be pretty hard to make pairs trading work in practice. It's just a too old idea and it's being done too much and you're going to have a tough time finding suitable pairs. You should improve your math a lot and think of a better algorithm ;)
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