Using Correlation to find a pairs trade

One of the strategies that I use for trading setups is the implementation of a pairs trade. For those not familiar with this, here is a brief description:

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Example of pair trade graphical representation

Example of pair trade graphical representation

The pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy.[1] The pair trading was pioneered by Gerry Bamberger and later led by Nunzio Tartaglia’s quantitative group at Morgan Stanley in the 1980s.[2][3]

The strategy monitors performance of two historically correlated securities. When the correlation between the two securities temporarily weakens, i.e. one stock moves up while the other moves down, the pairs trade would be to short the outperforming stock and to long the underperforming one, betting that the “spread” between the two would eventually converge.[4] The divergence within a pair can be caused by temporary supply/demand changes, large buy/sell orders for one security, reaction for important news about one of the companies, and so on.

Pairs trading strategy demands good position sizing, market timing, and decision making skill. Although the strategy does not have much downside risk, there is a scarcity of opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity.

So how do I go about finding suitable pairs of stocks? One of my tools that I use is the Correlation Tracker on the Select Sector SPDRs website. An example of one that I am reviewing today:

The trade for this pair goes as follows:

1) Long 1 lot of XLE (last closing price is 74.85) 

2) Short 2.25 lots of $SEF (last closing price is 33.05)

Note: If you don’t think they cross, but instead repel against each other, do the reverse for 1 & 2 above.

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