The Prop Trader's Chronicles: Short-Term Proprietary Trading Strategies for Both Bull and Bear Markets

PAIR TRADING AND VARIATIONS

The basic idea of a pair trade should be familiar to most traders. If not, the idea of a pair trade is to find two correlated and co-integrated stocks (based on historical data and typically with the requirement that the two stocks are in the same sector, although this may vary with your particular twist on the original base strategy) and then taking a long position in one and a short position in the other. Of course, your criteria for which one to go long on and which one to go short on would be based on your specific pair trading strategy's core concept.

In the classic pair trading model, a purely technical approach sets the long/short criteria by always going long on the stock that is short-term underpriced and going short on the stock that is short-term overpriced. This may be based on a price ratio between the two stocks or some other similar criteria. Alternatively, another classic pair trade strategy is to use fundamental values of the two stocks in order to decide which one is relatively underpriced (to go long on) and which one is overpriced (to go short on) based on price-to-earnings, price-to-book, or some other fundamentals-based value.

In general, the classic pair trading strategies were designed for over-night positions. Even if you choose to run these strategies with overnight position, it's still worth considering the basics of tape reading that you learned earlier in this book in order to optimize your entries and exits, and to reduce ...