4 – M2L6 07 Finding Pairs To Trade V4

To find good pairs to trade, we want to find pairs of companies that have economic links. It’s common to find stocks that are in the same sector and country. It’s also good to look for a less obvious but still meaningful connections. For instance, companies that trade internationally maybe affected by trade decisions by their respective governments. For example, steel companies in the United States and steel companies in China maybe influenced by political decisions made in either or both countries. Two companies may be suppliers and customers within the same supply chain. For instance, a textile supplier sells to a clothing retailer. A decline in clothing sales may impact the retailer first and then impact the textile supplier a bit later. Two similar companies maybe trading in separate countries and time zones. For example, a pharmaceutical company in India may see its stock rise due to strong international demand for its medicines. A few hours later, a similar pharmaceutical company in Germany may also see its stock rise. Notice in the last two examples, we see a lag between when one stock moves and the other moves in the same direction. A time lag is a good scenario to look for in pairs trading. If we see stock A move upwards and expect Stock B to move upwards later as well, then we can place a trade after Stock A moves, but before stock B moves. After Stock B moves as expected, we can close our positions. Once we found a pair of stocks based on economic links, we can check if those stocks are in fact good candidates for pairs trading. We check the pair by calculating the spread. If the spread appears constant over time, it’s likely stationary. Recall that a series is stationary when its mean, variance and co-variance are stable over time.

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