The Japanese stock market has been non-directional and unstable
for more than ten years and fully reflects the ailing Japanese
economy. Looking around the world, it is hard to find any
traditional financial products profiting steadily under this
situation. What is an investor to do? Pair-trading is a relative
value investment strategy that seeks to minimise market risk
and take advantage during such unstable times.
The term relative value covers a variety of low volatility
trading strategies with the consistent theme of attempting
to reduce market risk. In other words, the manager seeks to
generate a profit regardless of which direction the markets
are moving. All relative value strategies minimise market
risk by taking offsetting long and short positions in related
stocks, bonds and other types of securities.
AGS specialises in pair-trading which means taking equal
and offsetting long and short positions in two different stocks
which have diverged from their recent normal price patterns.
From a statistical viewpoint, securities tend to form short-term
price patterns based on the cumulative expression of market
sentiment. But no investment strategy is without risk and
all relative value investments strategies (including pair
trading) seek to replace market risk with "correlation
risk" where the prices for two securities are expected
to follow a particular pattern.
How exactly does pair trading work?
If the market goes up, anyone can easily make profit by buying
ETF or investing in a fund managed by a good manager. But
when we are not sure the market will go up, can we not make
a profit from the stock market? Is it impossible to get a
profit in a bear market? The answer to both questions is "NO".
Let's look at exactly how pair trading works in very simple
terms by taking the example of two stocks A and B.
You are not confident of a recovery in the market and not
sure if the Nikkei or Topix will go up or not but you believe
stock A's business, products and market are attractive. Still,
considering the market, you can't feel sure stock A will go
up. At the same time, you think stock B is clearly worse than
A and you feel certain the performance of stock B will not
surpass the performance of stock A in any case. If your analysis
is correct, you can make profit by doing a pair trade as shown.
Suppose you buy stock A with 1 million yen and sell short
stock B with the same amount. Here are two possible outcomes.
Scenario 1: The Nikkei drops 5 % over a month
Stock A couldn't avoid falling but only by 2 %. Stock B reacted
more to the down market and it dropped 6%. Your A investment
sees a 2% (20,000 yen) loss and stock B sees a 6% (60,000
yen) profit. If you exit the pair you could net 40,000 yen.
Scenario 2 The Nikkei rises 5% over a month
Stock A (the 'good' stock) rises faster than the index reaching
7%. Stock B (the 'bad' stock) also goes up but only by 3%.
You see a 70,000 yen profit on A and a 30,000 yen loss on
B. If you exit the pair the net profit could be 40,000 yen.
How to identify pair-trade opportunities
Once you understand the basic pair-trade concept the question
quickly becomes what stocks to buy and sell, in other words,
how to match up the pairs. It is also critical to know when
to enter the trades and when to exit. While there are many
ways of matching pairs and identifying the timing for pair-trade
opportunities, the three main ways to study pairs of securities
are as follows:
(1) Fundamental approach
The fundamental approach is the relative comparison of fundamental
data using indexes and other reports (see list). With this
approach, comparisons between similar types of securities
are generally going to be more effective. The holding period
for these pairs tends to be longer than the other approaches.
Timing for the entry and exit is more difficult to formalise
because fundamental data is not real-time.
Price to Book Value Ratio (PBR)
Price to Earnings Ratio (PER)
Return on Equity (ROE)
Return on Assets (ROA)
Sales Growth Rate
Profit Growth Rate
Sales Profit Ratio
Sales Cash-Flow Ratio
(2) Technical approach
This approach selects securities using one or more types of
technical analyses. Merits of this approach are that securities
can be selected across sectors and industries and the timing
signals, being based on market data, can be readily tracked.
This approach depends entirely on the effectiveness of the
indicators used. Pros consider the following list of indicators
to be reasonably effective.
Moving Average Rate of Change
Comparison of Moving Averages between Two Periods
Relative Strength Index (RSI)
(3) Statistical approach
This last approach works by applying advanced statistical
models to historical market data using sophisticated computer
programmes. This approach often includes aspects of both 1
and 2 above and, therefore, it can be said that it allows
for the widest possible analysis. This approach requires powerful
computers and advanced programming skills to implement. The
concept of "mean reversion" is frequently at the
heart of this approach. Mean reversion means that the relative
prices of correlated securities tend to revert to a statistical
average over a specified time frame.
AGS managers develop and operate highly advanced statistical
modelling software and pair screening filters. We conduct
seminars from time to time in Tokyo for those interested in
learning more about our methods and practices. Currently,
the clients for our technology include Japan's top regional
banks and investment corporations and the clients for our
investment partnerships include wealthy individuals seeking
good returns with relatively low value at risk.