1

A Presentation by AlphAmerica Asset Management and PairsTrading.com on

Pairs Trading: Leveraging Pairs Trading: Leveraging Expanding TechnologiesExpanding Technologies

Prepared by:

Douglas S. Ehrman

For more information, please contact us at 312.961.7063 or info@experityfund.com

2

Pairs Trading is the synthesis of 3 basic elements:

The Elements of Pairs TradingOverview

The Market Neutral ElementThe Market Neutral Element

The Arbitrage ElementThe Arbitrage Element

The Technical Analysis ElementThe Technical Analysis Element

Market neutrality is central to pairs trading because it drives how trades Market neutrality is central to pairs trading because it drives how trades are built and analyzed, it defines relative risk metrics & it serves as the are built and analyzed, it defines relative risk metrics & it serves as the basis for the overall trading strategy.basis for the overall trading strategy.

Arbitrage is central to pairs trading because it provides the framework Arbitrage is central to pairs trading because it provides the framework for the success or failure of a trade, and, therefore is the basis of for the success or failure of a trade, and, therefore is the basis of absolute risk management.absolute risk management.

Technical analysis is central to pairs trading because it provides many of Technical analysis is central to pairs trading because it provides many of the tools by which a trader may make decisions about both the quality the tools by which a trader may make decisions about both the quality and the timing of any potential trade.and the timing of any potential trade.

3

Many types of neutrality must be considered:

The Market Neutral Element

Sector or Industry NeutralitySector or Industry Neutrality

Market Capitalization NeutralityMarket Capitalization Neutrality

Beta NeutralityBeta Neutrality

A pairs trade that crosses sector or industry lines may be statistically A pairs trade that crosses sector or industry lines may be statistically attractive, but each leg of the trade is acted on by different market forces attractive, but each leg of the trade is acted on by different market forces that may affect the ultimate success of the trade.that may affect the ultimate success of the trade.

Pairing stocks with significantly different market caps may leave a trade Pairing stocks with significantly different market caps may leave a trade vulnerable to regular market rotations.vulnerable to regular market rotations.

Pairing stocks with significantly different betas builds a market direction Pairing stocks with significantly different betas builds a market direction bet into a trade where it may not be wanted. While total beta neutrality is bet into a trade where it may not be wanted. While total beta neutrality is very difficult, a pairs trader must always be aware of the betas of the two very difficult, a pairs trader must always be aware of the betas of the two stocks he or she is pairing.stocks he or she is pairing.

4

Share Neutrality vs. Dollar Neutrality:

The Market Neutral Element

Share NeutralityShare NeutralityThe classic “spread” tradeThe classic “spread” trade

Not really market-neutralNot really market-neutral

Creates situations of proper analysis while still losing moneyCreates situations of proper analysis while still losing money

Pure “pairs” tradePure “pairs” trade

Assures proper analysis leads to profitsAssures proper analysis leads to profits

ExampleExampleStock A - $10 Stock B - $5Stock A - $10 Stock B - $5

Share Neutral SpreadShare Neutral SpreadLong 1000 Shares A = $10,000Long 1000 Shares A = $10,000Short 1000 Shares B = $5000Short 1000 Shares B = $5000

Dollar Neutral PairDollar Neutral PairLong 1000 Shares A = $10,000Long 1000 Shares A = $10,000Short 2000 Shares B = $10,000Short 2000 Shares B = $10,000

Dollar NeutralityDollar Neutrality

Market Falls 20%, Stock A OutperformsMarket Falls 20%, Stock A OutperformsStock A - $8.50 Stock B - $4Stock A - $8.50 Stock B - $4

Long 1000 Shares A = $8,500Long 1000 Shares A = $8,500Short 1000 Shares B = $4000Short 1000 Shares B = $4000Net = Loss of $500Net = Loss of $500

Long 1000 Shares A = $8,500Long 1000 Shares A = $8,500Short 2000 Shares B = $8,000Short 2000 Shares B = $8,000Net = Profit of $500Net = Profit of $500

5

Price Ratio of ABC / XYZ

1

1.2

1.4

1.6

1.8

2

2.2

2.4

The Arbitrage ElementThe Importance of Correlation

ApplicationIf ABC and XYZ are highly correlated, the ratio of their two prices will be very stable when considered over a long period of time.

Over time, the price ratio stays very close to its historical average, in this case, about 1.5.

6

ApplicationDespite the high level of correlation, there will be a degree of fluctuation when the price ratio is considered across a shorter period of time.

Price Ratio of ABC / XYZ

11.11.21.31.41.51.61.71.81.9

2

1/1/

03

1/15

/03

1/29

/03

2/12

/03

2/26

/03

3/12

/03

3/26

/03

4/9/

03

4/23

/03

5/7/

03

5/21

/03

6/4/

03

6/18

/03

7/2/

03

7/16

/03

7/30

/03

8/13

/03

8/27

/03

9/10

/03

9/24

/03

There is oscillation around the average historical price ratio.

By entering a trade at an extreme, there is a high probability that the direction of the ratio will reverse and the pattern will repeat.

This process is called mean reversion.

The Arbitrage ElementThe Importance of Correlation

7

ApplicationMarket neutrality eliminates most of the affects of movements in the general market.

Correlation analysis compares the strength of the relationship between the long portfolio and the short portfolio.

In a properly constructed portfolio, mean reversion occurs when the long and short portfolio return to their historically average relationship.

Mean reversion is an example of relative-value arbitrage which is based on an implied or assumed convergence of a pair’s price ratio back to its historical average.

The Arbitrage ElementMean Reversion

8

In most cases, pairs are not as “perfectly” range bound as in the below example.

Price Ratio of ABC / XYZ

11.11.21.31.41.51.61.71.81.9

21/

1/03

1/15

/03

1/29

/03

2/12

/03

2/26

/03

3/12

/03

3/26

/03

4/9/

03

4/23

/03

5/7/

03

5/21

/03

6/4/

03

6/18

/03

7/2/

03

7/16

/03

7/30

/03

8/13

/03

8/27

/03

9/10

/03

9/24

/03

The pair must be considered as a single trading unit.

Considering the price ratio creates a single dynamic, dollar-neutral vehicle to which the appropriate indicators are applied.

The Technical Analysis ElementNon – Perfect Pairs

Technical indicators, when applied to the pair, give the trader the tools needed to gage proper entry and exit points; they dictate the timing of pairs trades.

9

The increasing availability and decreasing cost of technology is allowing more and more traders to easily begin trading a pairs strategy.

The Investment Process

Arbitrage Element

Technical Analysis Element

Market Neutral Element

Model or Screening ToolModel or Screening Tool

Fundamental / Technical OverlaysFundamental / Technical Overlays

Additional Statistical FiltersAdditional Statistical Filters

PAIRS PORTFOLIOPAIRS PORTFOLIO

10

A Pairs ExampleCross- Sector Opportunities Exist

These relationships tend to last for long periods…

1990 - 2003

International Paper (IP) vs. Kellogg (K)

11

Applying Pairs Techniques Applying Pairs Techniques to Futures Tradingto Futures Trading

12

Analyzing Similar Commodity Types

Futures with similar characteristics

Futures with inverse relationships

1. Futures on Stock Indices2. Energy Complex3. Agricultural commodities4. Interest Rate Futures5. Precious Metals6. Currencies

1. Gold and the U.S. Dollar2. Stock Index Futures and Interest Rate

Future in Certain Economic Environments

3. Some Currencies

13

Analyzing Similar Commodity Types

The Euro Currency

Swiss Franc

14

Analyzing Similar Commodity Types

Ratio of the Euro divided by the Swiss Franc

15

Analyzing Similar Commodity Types

Crude Oil Futures

Heating Oil Futures

16

Analyzing Similar Commodity Types

Ratio of Crude Oil divided by Heating Oil

17

Natural Correlation

December Gold

August Gold

18

Natural Correlation

Short-term Spread Trading of the Same Commodity Different Months of Expiration

December Gold – August Gold

1. Always move in the same direction2. Move at different rate3. Constantly create short-term trading opportunities4. The range is clearly defined5. Easy to identify entry and exit points6. Obvious risk management techniques