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Pairs Trading Or Pear Shaped?

To date I don’t believe I have discussed Pairs Trading on this site. While this style of trading isn’t something that I personally specialize in, there are those who make a good living using such a strategy. The textbook definition of pairs trading is a market neutral trading strategy that matches a long position with a short position in a pair of highly correlated instruments. This could be two stocks, ETFs, currencies, or options.

In a perfect scenario the long position rises and the short position falls, although this is not required to be profitable on the trade. You can also profit if the long position rises more than the short position falls and vice versa. This style of trading can be traced back to the early 1980s when Morgan Stanley assembled a group of math and physics wizards along with computer scientists. Involving fairly complex statistical modeling, these quantitative programs would have been difficult to grasp by the average Joe out here trying to understand them. That is why you have me, here to make sense of it all for you and put it into terms even your golden retriever can understand.

An example of such a trade was mentioned by Joe Fahmy this morning on Twitter. I love Joe’s commentary over at TheNextBigMove Blog.

Joe highlighted two stocks that would have made one hell of a stellar pairs trade. If you were tasked in Q4 of last year to put on your best pairs trade idea in stocks for the first quarter of 2019, you might not have thought about pairing McDonalds and Weight Watchers. If you did you might have thought that with so much emphasis on health and physical wellness these days it would be wise to be long Weight Watches and short McDonalds.

And you would have been wrong.

Weight Watchers (Red Line) has been cut in half on the year while McDonalds is up ten points.

The WEIGHT of the evidence continues to show we will remain pear shaped as evidenced by this pairs trade. 🙂

Happy Humpday.

Trent J. Smalley, CMT

Posted by Trent

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