By Chris Jenkins, Managing Director at TORA, an LSEG business
Since equity pairs trading was first introduced to the market in the 1980s, it has become immensely popular amongst investment managers. It has evolved from its original incarnation of matching a long position with a short position in two correlated stocks (still the most common type of pairs trade) to encompass a much broader landscape of strategies. Pairs trading can now be conducted cross-region, cross-currency, cross-asset, and cross-broker, with strategies including not only stock components, but also futures/options, ETFs, baskets, bonds, FX, crypto/digital assets, and more.
In this article, we look at how pairs trading is evolving, and what kind of functionality buy-side firms should expect from their PMS, OMS and EMS solution vendors in order to support their changing needs.
Market Volatility
In 2022, we saw a significant rise in market volatility brought about by inflation pressures, expectations for interest rate hikes and geopolitical tensions. As a result, many investment firms, including those who have traditionally focused on equity long/short, long-only or other directional strategies, began to look at market-neutral strategies as an alternative source of alpha.
This has triggered an even stronger interest in pairs trading, which can offer great flexibility when establishing market-neutral positions. Having the ability to create and manage pairs that can include not only stock components, but also futures/options, ETFs, baskets, bonds, FX, crypto/digital assets and more, allows investment firms to make the most of the types of non-directional, volatile markets we are facing today.
However, despite the wide variety of pairs strategies now being traded, traditional PMS, OMS and EMS systems have been slow to adapt, particularly from an algo trading perspective. This means that many firms have had to adjust their pairs trading workflow to accommodate system deficiencies rather than the other way around, i.e. having the ability to configure their systems to match their preferred workflow.
Market Neutral Pairs Strategies
There are of course various types of pairs strategy that allow firms to lock in volatility while remaining market neutral. Some of the more common ones are CD arbitrage (long CD, short stock of the same issuer or vice versa), relative value arbitrage (stock versus futures), AH arbitrage in Asia (‘A’ shares versus ‘H’ shares), ETF/index arbitrage, StatArb & other mean reversal strategies, and countless more.
However, in order to create, execute, manage and value these types of strategies, it is vital that firms have the necessary functionality within their PMS, OMS & EMS systems to fully support pairs trading in all its forms, particularly where there is any kind of cross-region, cross-currency, cross-asset, or cross-broker aspect involved. Opportunities can be quickly lost when a firm has to adapt its pairs trading workflow to overcome system deficiencies, rather than being able to configure and adapt the system to match its needs.
System Flexibility
It is important that firms remain flexible when it comes to pairs trading. Firms need to access a comprehensive range of pre-defined market-neutral pairs strategies as standard, enabling them with the ability to create their own, tailored to suit their requirements.
Various algorithmic and automated execution styles are available to firms, each with fully configurable rules around how each leg of a pair is handled under different conditions. Advanced TWAP execution algorithms, which can be fine-tuned around desired levels of passive and aggressive slices, allow for partial hedging in specific circumstances, reducing the impact of large pairs orders. There are also systems that allow cross-currency pairs to be dynamically auto-hedged, using pre-defined or real-time FX rates to maintain FX neutrality as well as market neutrality.
Market volatility forces out the weak players and can stagger even the most capable predictors. Fortunately, by using market-neutral strategies like pairs trading, traders and investors can uncover profits in all market conditions.
Buy-side firms have long understood the benefits of pairs trading, and pairs strategies will continue to provide a rich source of alpha for firms who are able to use them in new and unique ways. However, in order to do that, firms need to have the right tools available, ones that give them the control, flexibility, and rich functionality they need in order to stay competitive in such a fast-evolving market.
As firms seek alternative ways to capture alpha by locking in current market volatility and increasingly adopt market-neutral pairs strategies, it is essential that they are able to operate at scale and not be restricted by the capacity of single broker engines. By adopting a scalable, cloud-based, broker-neutral platform, firms can equip themselves with everything they need to support their current and future pairs trading activities to prosper whatever the market environment.
