I have received a few comments recently regarding pairs trades and how one goes about looking for them. I don’t have any one specific tool or scan that I use to uncover opportunities for pairs trade setups, but I thought I would lay out some ground work for how it typically unfolds for me.
To help in this, I will use a Correlation tool from the Select Spdr website and so I will use this as a base for walking through finding a pairs trade idea. Here is an example from today using the Correlation tool to find 2 stocks with negative correlation near 1:
Using TLT as the initial ticker and adding XLF as the comparison ticker you can see several things in the above chart:
1) 2 areas noted in the RED box where price of the 2 tickers was correlated.
2) Now a distinct moment in time where price has been repelled in the 2 tickers showing a gap distance of over 30%.
3) On Balance Volume increase starting from the most recent Price divergence (late July)
So what is the opportunity here? For a pairs trade idea, it would seem appropriate to play for a mean reversion back to correlation in these two at some point in the future (history rhymes). Here is the trade:
1) Short 1 lot of TLT
2) Long 8.75 lots of XLF
P.S. Note that one needs to consider to the current action in TLT as it relates to Global issues in Europe. This trade is provided as an example of what to look for and the goal of a trade.