Friday, February 6, 2009

Pairs Trading Can Be Risky!

So, I thought I’d check up on a pairs trade that I was considering entering last March. Pairs trading involves taking advantage of a correlation between two markets or stocks. When the pairs diverge, you short the higher one and buy the lower one, hoping that they will come back together in the future, and you will capture the difference as profit.

I noted one such divergence between the oil market and the clean energy sector. They usually are highly correlated because higher oil prices makes investment in alternative energy technologies more attractive. Early last year, as oil went on its historic bull run, the correlation broke down. I saw an opportunity for a pairs trade emerge. The chart below shows the divergence:
(from Yahoo Finance)

I have to say I’m not exactly sure why I did not take on the position. Anyhow, I did not, and it was probably a good thing. The blue dot on the graph is when I would have put on the position. I would have been short USO, the graph on top, and long PBW, the graph on bottom. As of about July 1st, I would have been carrying about a 40% loss on USO, and about a 20% loss on PBW!!! Ouch! Even with a leverage of 2-to-1, I would have stopped out! With out leverage, I would have had to wait until December to realize a loss of about 60% on PBW and a gain of about 80% on USO, for a net of about 20%.

Looking deeper into the pair, the correlation coefficient is 0.49, which is quite a bit lower than the 0.70 that some people consider a minimum for a significant correlation. However, I like the logical argument behind the correlation and attribute the low coefficient to my small data set that only goes back to 2006.

The point of this article is that, sometimes, markets can irrationally diverge for longer than you can stay solvent. Even a hedged pairs trade can be very risky under leverage. But, if you’re careful and patient, you can make money in a logical way!


Vasyl said...

Well, you are right.. But the only thing why it could happen is breaking of two basic rules for pairs trading: 1)bad entry, 2)money management. You should have took a look on couple signals to determine a good entry but not only the fact that there was a stretching. And in ANY CASE you should have took a loss 1-2-3-..5% (depending of a risk of your strategy) and not taking 60% which would have killed anybody!))

Best regards, Vasyl

Lucas said...

Hey Vasyl,

Thanks for the comment. I'll have to address these issues in later posts...