If you’ve been trading for any length of time, you’ve probably noticed that the stocks you own have a tendency to move with the overall market. That’s great when the market goes in the direction that you want your stock to move, but rather irritating when the market moves against your position.
A common way to eliminate some of the market risk is through the use of pairs trading. You can find plenty of information on this style of trading on the internet, but the basic concept is that you own a long position in one security while simultaneously going short another security. In many cases the two securities will be stocks in the same sector, like Ford and GM, or Coke and Pepsi. But you can also pair a stock with a market-tracking index, like GE and SPY, which more directly addresses the problem of market risk.
The key question, of course, is how to know when you should be long the stock and short the index, and when you should be short the stock and long the index. Many people use a ratio of the prices of the two securities as a guideline. For example, the chart below plots the ratio of the price of GE over the price of SPY. The ratio has been multiplied by 100 just to bring it into a more typical range for prices.
When the price ratio is rising, you want to be long the numerator in the ratio (in this case, GE), and short the denominator (SPY). Conversely, when the ratio is falling, you want to be short GE and long SPY. The relative position sizes are also of great importance, but delving into that topic is beyond the scope of this newsletter.
Again, there are plenty of ways to determine which direction the ratio is likely to move. However, one that you may not have run into before is to apply our old friend the 2-period RSI, or RSI(2), to the price ratio. The chart below is identical to the one above, but with RSI(2) shown in red in the lower pane:
As you can see, when the RSI(2) value dips below 10, it is often a signal that the price ratio is about to rise. RSI(2) values above 90 often signal an upcoming decline in the ratio. However, if you look closely you will also notice that RSI(2) alone is not a perfect predictor of changes in the ratio. For example, in mid-June the RSI(2) peaks above 90 twice. After the first time, the ratio falls slightly but then makes a strong move upward.
It’s not surprising that RSI(2) might need a little help from some additional filters to make this strategy more robust. In fact, very few strategies rely on a single indicator. The important thing is that RSI(2) does a great job of identifying potential entry points for a pairs trade, and also allows you to quickly filter out a lot of the noise in the price ratio plot.
If you already include pair strategies in your trading toolbox, consider adding RSI(2) (or even ConnorsRSI if your platform supports it) to your other indicators to help you evaluate your trades. If pairs trading is new to you, it’s an area worthy of some further exploration.