Tip #2 – Price Ratio Analysis
Pair trading often succeeds or fails based on price ratio analysis, which is the core of the system. The maths are simple: in two correlated stocks what is the ratio of stock A to stock B (price A/price B)? The closer the stocks are in price, the closer the ratio will be to 1. For example, if stock A is trading at $55/share and stock B is at $58/share, the price ratio is 0.95.
Watch For Changes in the Current of the Stream:
Correlated stocks, and to a great extent co-integrated stocks, over time tend to move up and down together like two fish swimming side-by-side. That’s a logical outcome of the mathematical relationship, which reflects the fundamental reality. The same economic factors, such as regulatory environment, macroeconomic trends, overall customer demand etc. affect both stocks similarly. Using historical data and pair trading software, a trader can establish a solid baseline for analysis. The longer the trading history of the pair, the firmer the backtested trading parameters derived from past price ratio deviations may be.
