Pair Trading
This trading strategy involves following a pair of securities whose prices are correlated i.e. the difference in their prices is consistent (though not exactly) over a certain time period (few months or more) and selling one and buying another as soon as this price difference widens expecting that it will eventually fall back to its usual level. This may be illustrated as follows:
Suppose that Aisapaisa (AP) and Aisakaisa (AK) are two companies whose prices seem correlated, the difference in their prices generally hovers around the Rs. 100 mark but recently this difference has increased to Rs. 120, in such a scenario a pair trader would sell AP if he thinks it is a case of overpricing and/or buy AK if he thinks it is a case of underpricing. Once the difference returns to Rs 100 the trader would end up pocketing Rs. 20 on each such transaction.
Typically stocks chosen to constitute a pair happen to be fierce competitors in the same sector (with similar product profiles, operating strategy etc.), they must also have stable and similar beta values, for example Bajaj and Hero Honda.
You may check for consistency in price difference by comparing the price charts of the two stocks however one must ensure that logical reasons are attributable to the same sustaining in the medium to long term as well.
Tags: Daily Funda
October 31st, 2008 at 11:53 pm
Tata motors and MUL is another good example. Btw how will an investor determine if the A is overpriced or B is underpriced? Will it not be a better strategy to identify the strongest scrip in the sector and long on that and short others. It will be particularly useful in volatile market.