Welcome to the first of many installments on how to become a great Pairs Trader. It's important not just to understand what works correctly with Pairs Trading but also to keep your eyes out for a couple of important potential barriers to making money. Here we are going to focus on the two most important ones - earnings and trending. The two are sometimes interrelated, but we feel it is best to describe them differently so that you can better focus on each as an individual element.
First, let's talk about earnings. As you probably know, public companies on the major exchanges announce earnings on a quarterly basis. In almost all cases these earnings come out on a date that has been planned and announced in advance. This is common knowledge but what impact does this have on Pairs Trading? In a nutshell, a stock's performance very often behaves differently immediately surrounding earnings season and this can disrupt any patterns that have been formed with a pair over a short interval. In effect, an earnings announcement can throw a monkey wrench into the "typical" behavior of a stock. While some traders focus on making money during earnings season, Pairs Traders tend to avoid these events for the reason just described. PT Professional's analysis engine examines when each company's earnings come out and strives to avoid these pattern disruptions - and thus you will usually not see a pair trading on a given day if either of its stocks are announcing earnings. While it's difficult to pinpoint how much more efficient you will be by avoiding trading a pair on an earnings announcement, it can easily save you several percent on your returns by eliminating these events altogether.
Next, we want to try to avoid stocks that are trending in one direction. In other words, the stock has effectively broken its pattern and is now moving either up or down continuously. Like with earnings, this type of event will throw off the pattern of a pair.Â However, unlike with earnings which is a predetermined event, a stock that is trending is often difficult to pinpoint because identifying it is often subjective. Getting better at identifying trending is perhaps the key hallmark of a great Pairs Trader. Even the top professionals will tell you that there are always situations that are unpredictable, but with a little bit of time and experience you will get better at spotting unfavorable trends and avoiding some potential money losing trades. We will have more on this topic in the upcoming months, but for now a key takeaway for new Pairs Traders is to understand that these types of trends do occur and to manage your position exits with appropriate stop orders.