Do you remember the penultimate chapter of your Class 10 math book? Mine was statistics. Like this reporter, maybe you never liked that chapter, and even questioned its use in daily life.
What if I tell you today that that chapter can help you generate up to 35 percent returns every year? This is what Sonam Srivastava believes, banking on her Pair Trading strategy.
Pair Trading is simply taking opposite positions in two highly correlated stocks. For instance, HDFC Bank and ICICI Bank tend to move in tandem. But, if for some reason this correlation is broken, one can initiate a trade in them with the assumption that they will revert to their mean.
Srivastava, who is a chemical engineer by education and stock market professional by choice, says this strategy, if used with enough safeguards, can deliver 35 percent returns with risks limited to 7 percent — a 1:5 risk-reward ratio.
Trade setup
Setting up the trade for this strategy needs access to historical data and knowledge of the principles of basic statistics. Srivastava usually trades in pairs that have a reason to be correlated rather than those with incidental correlation without any plausible reason. For instance, stocks from the same sector.
Step 1: download historical price data for all stocks from a sector. The data should be for the past several years to be able to make a strong case.
Step 2: calculate the correlation coefficient for every pair of stocks using the data. Excel has a simple formula to calculate the coefficient, which ranges from -1 to +1. A perfect positive correlation is when the value is +1, whereas -1 means there is a perfect negative correlation. A 0 means there is no correlation.
Step 3: find the pairs that have a high correlation coefficient. The closer to 1, the better.
Step 4: now you need to scan daily for instances where the correlation is breaking. For instance, usually if the correlation between NTPC and Tata Power is 1:2 (or 0.5), but right now stock prices for both have moved irrationally — two points down for NTPC and 10 points up for Tata Power. This movement is an anomaly and creates a good trading opportunity.
Step 5: you can now short Tata Power and go long on NTPC in the futures market, with the assumption that the ratio between the prices will eventually move to the long term correlation coefficient.
Step 6: you need to wait for stocks to move to the mean or set a profit target from the trade, and then book the profit. The time horizon for such trades can be from a few days to several weeks. You should also put a stop loss of 5-10 percent on the pair.
As you can understand, this strategy requires trading in the futures market, which means a high capital requirement. Srivastava says one can also use options to bring down capital requirements as the margin required is usually lower in options, especially when you take hedged positions.
Risk management
The risk in this strategy arises from the fact that stock prices may not revert to the mean for a long time and may keep moving in opposite directions even after we have initiated the trade. An example is when correlation between the Nifty and the Bank Nifty was broken for a relatively long time during the pandemic.
One of the ways to mitigate risk is to diversify your trades. Srivastava advises that we should trade several pairs across sectors at one time. This will ensure that your losses are limited even if a few trades go wrong.
Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
