Thursday, February 24, 2011

Pair Trading Hedge Strategy

Hey all,

Today is going to be the first of a three part series discussing pair trading as a hedging strategy.

For those of you unfamiliar with the concept of pair trading, I will take some time to describe it. Essentially, pair trading involves tracking two equities, or other financial instruments over time, and how they move in relation to each other. For example, if we pick the two equities Coke (KO) and Pepsi (PEP) , we want to find an average difference in price between the two. Now on the programming side, which I will go into more in later parts of this series, we can read in a file containing the data for Coke's Stock Price and Pepsi's Stock Price and compute an average difference in price. Once we have this average difference, for clarities sake, lets assume the average difference in stock price is KO is on average $1 dollar more expensive then PEP. With the pair trading hedge strategy, anytime Coke moved more than $1 more expensive than Pepsi, we would short a predetermined amount of KO shares and buy a predetermined amount of PEP shares. The reasoning for this is that we expect these two stock prices to converge back to their average difference in price.

Come back for part two of this series, where I will demonstrate the coding techniques necessary to compute the price differences we need. In part three, I will demonstrate a successful pair trade using real life numbers and stocks!

If you are thirsty for more information on pair trading, click here!

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