Wednesday, 30 August 2017

Trading in Pairs

Finding Trading Opportunities:
 
By using linear regression techniques and the theory of return to the average, to identify trading opportunities in the equity market on the JSE. Linear regression is used to identify the general trend or direction that follows the share price. When the share price drifted too far from this linear trend, the average return theory indicates that the share price must adjust to its linear trend over time. These techniques can be used to identify the bargaining opportunities when a share price has traded too far below its trend, or sales opportunities than the share price trade well above.



Looking at the relative movement of two shares that follow each other due to fundamental and / or economic factors. Shares in the same industry, such as two local banks, gold mines or retailers, are a good examples. Then trade the divergence (A & B) or better the return to the mean.

By analyzing the relative mediation of these shares by using the same linear regression and average return techniques, a number of trading opportunities can be identified.
 
 
Or differently plotting both the relations onto one graph to highlight these action areas.  Below we can clearly see that GFI has outperformed ANG and a possible pair trade can be constructed.



Delving for possible correlated pairs:

The correlation coefficient (a value between -100% and +100%) tells you how strongly two variables are related to each other. A correlation coefficient of +100% indicates a perfect positive correlation. As variable X increases, variable Y increases. As variable X decreases, variable Y decreases. The other end of the coin, a correlation coefficient of -100% indicates a perfect negative correlation. As variable X increases, variable Z decreases. As variable X decreases, variable Z increases. Lastly a correlation coefficient near 0% indicates no correlation.


From the JSE Top 40 shares, I do find the following relationships:



Long/Short Pairs Trading:

Trading in pairs is a slightly more advanced strategy. This strategy uses derivative instruments such as contracts for difference (CFDs) or futures contracts to implement a market neutral, zero equity exposure strategy and requires a derivative trading account. Very big words there, allow me to explain.
 
By using derivatives, an investor can sell a share, which means that you will realize a profit when the share price decreases and vice versa. Short trading of a share is opposite to hold a share. If you buy Long the same amount in one share, than you are in another Short position, you have a net equity exposure of zero.

Using the same example as above, you can implement a market neutral strategy to utilize the deviation in the relative price movement of Nedbank and RMB Holdings Ltd (RMH:Johannesburg). A market neutral strategy means that you can make a profit regardless of the overall direction of the market. In this example, we expect Nedbank to perform better than RMB Holdings Ltd (RMH:Johannesburg), as RMH has deviated from its overall performance against Nedbank.

Long the shares that you expect to perform better (NED) and Short these you expect to underperform (RMH), your ownership will be in a profit as the relative price movement of the two shares is corrected against the General trend. The big thing about pare trading is that you can realize a profit, regardless of whether or not the share prices for the two shares involved, go up and down. The only thing that has to happen is that Nedbank should perform better, ie. higher than or less than RMB Holdings.

Pros:
Market Neutral
Less Volatile
High % Hit rate


Cons:
Risk Management is hard
Higher Margin needed for these two trades at once
Double Cost as you open two trades at one time
 
As you can see, applying these simple techniques can help an investor identify numerous trading opportunities and ultimately enhance the returns on their portfolios.

A wise man once said: “Opportunities are usually disguised as hard work, so most people don’t recognize them.”

Note:
 
As always, it is advised to double-check the validity of any trading opportunity identified by technical analysis with a healthy dose of fundamentals. If a company has just released a dreadful trading update and their share price falls, it might look like a bargain, but it is trading at those levels for good reason. Check out the SENS for all the latest company updates.


Trade with caution as the markets are very unstable and uncertain.
@Duplo123 or join us on Skype

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