Once a pair of stocks with a high correlation has been found, the next step is to divide the two stock prices so that the chart can show the historical relationship of this pair of stocks - the so-called "spread". In this way, the trader is able to draw conclusions as to whether possible cycles can be identified when looking at the spread. It is ideal if the spread moves around a mean value and forms a kind of trading range. Exactly these recurring divergences alignments of both stocks form the basis for so-called "divergence and convergence pair trades."
Figure 2 shows the development of the Caterpillar share (red line) and the Deere share (dark blue line) as well as the corresponding spread in the period from November 2009 to March 2011. The prices of both shares repeatedly go through phases in which a divergence or convergence can be observed. The spread shown in the lower part of the picture moved in a range between 0.86 and 1.0 during this period. It is therefore always a good idea to enter a pair trade when the spread reaches an extreme value, i.e. when one of the two limits has been reached.
Pair Trading in Practice
In the following a divergence trade will be shown: On March 1, 2010 (see point 1 in the chart), the spread of both stocks reached the upper edge of the range, which means that both stocks were again in line with each other and a renewed divergence was to be expected. To put this divergence pair trade into practice, half of the available capital was put into a Caterpillar short position, the other half into a Deere long position.
With this pair trade, the CFD trader thus bets on a renewed divergence of both price trends. Since both positions ("Legs") of the stock pair have the opposite direction, the trader is quasi market neutral. He speculates only on the change of the price difference and not on a certain direction of the total market. After the spread of both stocks had reached the lower limit of the range again in the following weeks (see point 2 in the chart), the pair trade was closed.
In general, when pair trading, it is important to note that closing the trade always requires closing both legs, which means that the long and short sides of the pair must be closed at the same time. You can see the result of this pair trade in the following table.
The divergence pair trade yielded a profit of 8.65 percent, excluding transaction and financing costs and currency effects, as at https://exnessbroker.net/mt4/ Caterpillar stock outperformed Deere. So the divergence of the two price trends occurred, and as we know, that's exactly what should be traded. The stock that was shorted did rise, but only by 4.7 percent. Thus, the loss on the short side was significantly lower than the gain on the long side. Thus, in this example, the performance difference of around 8.65 percent was captured as a profit.
Without risk it does not work
As you can see on the chart, there were further trading opportunities that could be realized profitably. Again and again, the two shares diverged and converged. With the help of the analysis of the spread, several profitable trades could be executed.
However, one thing is certain: Even if the pair trading strategy primarily pursues the goal of being market-neutral and thus apparently "safe" profits - a certain risk is always present even with this trading strategy. This includes, above all, the risk of an unforeseen event such as a profit warning, which can lead to a strong opposite price reaction. The other danger lies in the analysis of correlation data: No matter how long time series are evaluated and interpreted, it is simply impossible to make a 100% statement about the future development of the correlation. Therefore, in pair trading, as in all other trading strategies, it is necessary to monitor the positions regularly and to adhere to strict risk management.