Pairs Trading Strategy as Proxy for Swing Trading

It should be no surprise to learn that the most successful quantitative hedge fund founders were, at the beginning of their careers, successful convertible arbitrageurs. I was fortunate to be one of the earliest inventors/discoverers of the basic convertible arbitrage strategy.

The basics of convertible arbitrage revolve around the concept of relative value. When the convertible is demonstrably more valuable than the underlying shares, than the convertible arbitrageur purchases the convertible security and shorts the underlying shares. Reversing the trade when the relative values return to normal.

In the early days of the convertible arbitrage strategy, the position carried a positive cash flow and the reversal of the position could take many months until a more favorable opportunity made the position less favorable.

The relative value strategy follows into other quantitative strategies.

Most pairs trading strategies use two securities in the same economic sector that have movements that are highly correlated and co -integrated. They track each other almost perfectly, the ratio of the price of the two such stocks should be almost the same. When their relative movements deviate from their expected behavior, the strategy dictates that the relatively cheaper one be purchased and the more expensive one be sold short. A reversion to the mean relationship. Traders waiting for various deviations, trying to put trades on at maximum deviations. Hundreds if not thousands of pairs traders follow the same highly correlated co-integrated pairs. It becomes a game of chicken. Each trader trying to get the trade on at the best possible time.

Similar to what happened to convertible arbitrage, the returns on the strategy go down as the number of players participating increase. It is a limited universe. The amount of funds devoted to mean reversion pairs trading decreases the amount of profit to be made.

I have developed a swing trading strategy that uses the relative value of the pairs components. Like convertible arbitrage, the strategy uses a large portfolio approach, putting on lots of different positions in differing economic sectors to diversify risk. Many investors may find it useful in a long only portfolio.