What is a Market Neutral Strategy?

A Market Neutral Strategy is designed to benefit investors and traders in all market conditions. Whether the market goes up, down or sideways, the strategy should be capable of generating positive results with very low risk.

The idea behind any Market Neutral Strategy is to find highly correlated stocks and act upon their contraction or expansion. You have probably noticed that stocks in the same sector have similar chart patterns. If the sector rallies, while most of its components go up, some stocks go up more and some less. The same is true during declines. In other words, there is usually a price correlation between stocks in the same sector. Implementing the strategy means finding a pair of stocks, which are highly correlated on a long, medium and short-term basis (depending on profit objectives and risk tolerance), and buying (going long) one stock and simultaneously selling short another. This strategy can be applied using indistinctively the purchase/sale of index or stock futures, and/or the purchase/sale of the stock; the two legs of the strategy require the same amount to be invested: the cash in the spot market, the nominal amount for futures.

Chart 1 below shows the price action of two stocks from the same sector. Note how closely correlated these stocks are. Instead of predicting the future direction of these equities, a market neutral strategist tries to identify the historical price difference of this pair, and acts upon temporary contraction or expansion of this difference. In other words, a pair of stocks becomes a trading vehicle, which has an extremely high probability of staying within a range.

Now take a look at Chart 2 below. This is NOT the chart of a stock or an index. This is a chart of a price ratio of two indexes over the last several years (Index 1 divided by Index 2). No matter what the stock market does, the correlation remains the same. Knowing the historical difference, the idea is to buy at the bottom of the range and to sell at the top. Since we are dealing with a pair of stocks or indexes (as the chart shows), "buying at the bottom" means buying one issue and shorting the other when the difference in price is historically big. Selling would be the opposite trade (shorting the first and buying the second).

A Market Neutral trader is not concerned with whether these stocks go up or down after initiating a position, he or she is only concerned with the difference of a price move of these two stocks.

In order to identify a high probability trade, PairsTrading.net not only finds highly correlated stocks, but also applies multiple technical indicators to these pairs, which allows the user to achieve ideal entry and exit points. For illustration purposes we applied a simple momentum indicator to the chart below (stock 1 divided by stock 2). Note how even a simple momentum indicator ideally points to an overbought and oversold condition in a range bound trade.

That said, there is no reason why there would always be contraction following an expansion. The pair positions are generally selected by statistical analysis and they can be characterised for many regular small gains and an occasional single large lost. Consequently success is normally dependent on rigorous discipline in cutting losses on taking incorrect positions, strict risk control, and diversification by creating as many pairs as possible to off-set the weak points of the portfolio.

Calculation of ratios.

In pairs trading, the purpose of the study is not the evolution of each of the assets separately, but the evolution of one asset with respect to another. Accordingly, a graphical analysis of the evolution of a pair shows the price ratio of one asset with respect to another.

This also explains why the investment in pairs of assets requires the same nominal investment in the two assets, going long in one asset and shorting the other. If you wanted to invest in a total amount of 1,000 in a pair of assets such that the value of the first one was 10 and the second was 15, you would buy 50 units of the first asset (500/10) and would sell 33 units of the second (500/15).

By way of example, observe the following data:

Asset 1	Asset 2	Ratio
100.00	100.00	1.00
95.35	106.34	0.90
99.90	105.42	0.95
99.40	102.96	0.97
97.83	106.31	0.92
99.73	107.63	0.93
103.63	108.25	0.96
105.44	110.95	0.95
103.13	113.40	0.91

It is the ratio analysis that enables us to observe whether or not the evolution of the two assets is similar.

By using the ratio instead of the rest of its values, what is observed in the graph is how the relative evolution of one asset changes with respect to the other. For example,

• Suppose we have two assets, one with a value of 10 and the other with a value of 20.
• If the first one changes to 11 and the second to 21, we would find:
• There is no change when subtracting one from the other, as the difference between the prices continues to be 10.
• The quotient when dividing one by the other has changed, from 0.5 (10/20) to 0.52 (11/21). The reason for this is that the first value has increased 10% (1 over 10) and the second has only increased 5% (1 over 20).

Why is it less risky to trade a pair of stocks than a single stock?

Let us use an example to illustrate this. Suppose we have:

• Patrimony of 10,000 euros.
• Stock of company A, which initially trade at 10 euros and end up trading at 11 euros.
• Stock of company B, which initially trade at 10 euros and end up trading at 8.50 euros.

Now we will consider three possible ways of investing in these stocks, whereby all options lead to a loss. We will evaluate the amount of these losses in order to determine which method of investment involves the least risk:

1.      A scenario where all the patrimony is invested in selling company A stock. The result is:

A)     Initially 1,000 shares are sold (10,000/10)

B)     Then 1,000 shares are repurchased at 11, or 11,000 euros (1,000 x 11)

C)    The result is a loss of 1,000 euros.

2.      A scenario where all the patrimony is invested in buying company B stock. The result is:

A)     Initially 1,000 shares are bought (10,000/10)

B)     1,000 shares are sold at 8.50, for 8,500 (1,000 x 8.50)

C)    The result is a loss of 1,500 euros.

3.      A scenario where half the patrimony is invested in selling company A stock and the other half in buying company B stock. The result is:

A)     The result is a Initially 500 shares are sold of company A (5,000/10) and 500 shares are bought of company B (5,000/10).

B)     500 shares of company A are repurchased at 11, or 5,500 euros (500 x 11), and 500 shares of company B are sold at 8.50, or 4,250 euros (500 x 8.50)

C)     The result is a loss of 1,250 euros.

As the loss in scenario 1 is less than the loss in scenario 3 (corresponding to the acquisition of the pair A/B) it may appear that given two stocks it could be less risky to invest in just one of them (leaving the question of which one to invest in) rather than invest in the pair constructed with the two of them. However, to complete the analysis the following information should be taken into consideration:

1.      In scenario 1, under the efficient markets theory, the probability of an unfavourable movement in this investment is 50%.

2.      In scenario 2, the probability would also be 50%.

3.      In the third scenario, assuming the worst possible correlation, namely zero correlation, the probability that the two unfavourable movements occur simultaneously is 25% (50% x 50%). In the case of positive correlation, the probability is even lower. Only in the case of perfect negative correlation, the loss has the same probability as in scenario 1 or 2, namely 50%.

The variance of a pair

• Defining the terms where
• is the standard deviation of asset A
• is the standard deviation of asset B
• is the correlation of assets A and B
• is the percentage of our portfolio invested in asset A
• the percentage of our portfolio invested in asset B

      Statistically, the following statement is always true:

      which would represent the volatility of buying two assets, whereas buying a pair (buying one asset and selling the other) would be represented by:

• Therefore, if =10%, =15% and =0%, investing half of our capital in each of the assets, if we buy the first and sell the second we would have:

  

• If =10%, =15% and =60%, investing half of our capital in each of the assets, if we buy the first and sell the second we would have:

  

• If =10%, =15% and =-50%, investing half of our capital in each of the assets, if we buy the first and sell the second we would have:

  

Conclusion: to the extent that the correlation is greater than zero the volatility of the pair will be less than the lower volatility of the two assets. Therefore the worst case scenario is that the correlation is zero, which is an unlikely scenario in assets of the same class.

What are the advantages of trading pairs?

Market Neutral Strategies can be used in any market environment. Obtaining a unique edge as described above and great comfort when designing this type of strategy, which has an extremely high probability of making money regardless of whether the stock market crashes or explodes to the upside is a huge advantage over directional bulls and bears.

Major financial institutions and hedge funds apply these strategies in a consistent manner

Less risk than directional trading

Performs equally well in bull or bear markets

Less stressful than directional trading

How can PairsTrading.net assist me?

The PairsTrading.net Market Neutral Trading System has evolved from the well-known correlation/convergence trading strategy (also called statistical arbitrage), which is widely employed by professional trading firms, hedge funds, and sophisticated independent investors to make profits without taking significant directional risks. The strategy focuses on signals for stocks and indices that are strongly correlated. The PairsTrading.net Trading System is the result of years of development and trading experience. Based on a collection of technical analysis tools, the multi-step system brings together a unique strategy, which is market neutral, meaning that it is designed to benefit traders and investors in all market conditions. We take pride in our quantitative analysis and research in order to assist you in your trading and investment decisions and show you investment avenues not known to the majority of traders.