Top Pair Stocks for Pair Trading

[rkkarnani]

It is pure mathematics. The web application doesn’t know stocks. It compares A and B. Creates ratio of A:B. When the ratio goes up or down from the mean ratio a trade is generated. This is pair trade.
Let me tell with e.g. there was a time when Maruti price was 2 times M&M Price. That is Maruti/M&m = 2. Like when m&m was 1000 maruti was 2000 like that. So for some reason maruti price shoots up to 3000 but m&m still stays at 1000. So now the ratio becomes 3. Now the system compares the current ratio 3 with medium term historical ratio, lets say 2. So when suddenly it moves to 3 from 2 in a short time there is a big deviation and so a pair trade is formed. It is basically Standard Deviation concept. There is a fundamental logic to this concept.
This is not only for stocks. You can apply this concept to any 2 comparable things, that have been historically similar but there is sudden deviation.
Check Bank nifty vs Icicibank. Press the ratio chart button. You can see that after nearly 3 years bank nifty vs icici ratio has peaked up and so there is a signal.

How to decide whether to SELL Stock'A' or BUY Stock 'A'!!? When I do backtest does the software decide which stock is to be Sold and which to be bought to initiate a Pair trade!?

 

[Smart_trade]

How to decide whether to SELL Stock'A' or BUY Stock 'A'!!? When I do backtest does the software decide which stock is to be Sold and which to be bought to initiate a Pair trade!?

@ RKK

When the ratio goes to +2.5 SD sell the numerator or 1st scrip and buy the denominator or 2nd scrip.When it goes to -2.5SD then sell the denominator and buy the numerator.

Software gives signal which stock to buy and which stock to sell.

@ pairtradepro

Can you write a few lines on how you use options if the trade goes against us.1-2 examples will help.

ST

Smart_trade

 

[umeshmandal]

Can anyone post a step by step process to calculate the standard deviation of two stocks!
If an actual example is given it would be still more useful.
Say a pair of HDFC and HDFC Bank: what details we need to calculate their Std. Dev.?
Of course the result can be seen on ur website, but just wish to understand the Std Dev better. I did try to Google it but at most places examples are for some Population related figures!

 

[pairtradepro]

standard deviation is square root of variance. variance is average of squares of mean. in my site i am using weighed SD to give more weightage to recent data.

 

[umeshmandal]

standard deviation is square root of variance. variance is average of squares of mean. in my site i am using weighed SD to give more weightage to recent data.

What period average is taken to calculate the variance!

 

[pairtradepro]

You asked how I use options with pair. A small example
Lets say there is Long ICICI and Short Bank Nifty Signal. I will decide which has more probability. If i feel ICICI going up is more probable than banknifty falling, then I would buy ICICI fut and buy bank nifty put. I will replace the doubtful leg with option. So when ICICI goes up by 5% and bank nifty goes up by 2%, I would have made better profit then shorting bank nifty fut. On the other hand by buying put i am reducing my risk in one leg.

If I am in this position
I would buy ICICI Fut and Sell ICICI High strike
and buy one Bank Nifty Put
when using options the overall risk definitely gets reduced.

 

[comm4300]

You asked how I use options with pair. A small example
Lets say there is Long ICICI and Short Bank Nifty Signal. I will decide which has more probability. If i feel ICICI going up is more probable than banknifty falling, then I would buy ICICI fut and buy bank nifty put. I will replace the doubtful leg with option. So when ICICI goes up by 5% and bank nifty goes up by 2%, I would have made better profit then shorting bank nifty fut. On the other hand by buying put i am reducing my risk in one leg.

If I am in this position
I would buy ICICI Fut and Sell ICICI High strike
and buy one Bank Nifty Put
when using options the overall risk definitely gets reduced.

there are periods when the co-relation tends to extend beyond 2.5SD OR when the co-relation entirely fails between the pair.


can you share your views on such situations.

 

[pairtradepro]

Yes that situation is common with all kinds of technical analysis. You can keep a stop loss of 1D. But I generally buy distant strike put or calls. So when positions moves away wildly I can restrict my max loss. When I enter a trade I fix the maximum possible loss and I run the position. That's what I do. By using option I lose some time decay but that's far better than holding position without protection.

 

[Smart_trade]

Yes that situation is common with all kinds of technical analysis. You can keep a stop loss of 1D. But I generally buy distant strike put or calls. So when positions moves away wildly I can restrict my max loss. When I enter a trade I fix the maximum possible loss and I run the position. That's what I do. By using option I lose some time decay but that's far better than holding position without protection.

Yes stoploss of 1 SD or 1.5 SD beyond our entry ( Reward to risk of 1:0 or 1.5 :1 ) seems a good idea.That will enable clean backtests without doing some kalakaari in protection.

Smart_trade

 

[pairtradepro]

A Stop loss like this work
> SD 1
> Time Exit (10 days) - In stocks and commodities magazines there was a nice article telling that time limit exit works better for pair trading.