Pairs Trading

From Investopedia

"Quants" is Wall Street's name for market researchers who use quantitative analysis to develop profitable trading strategies. In short, a quant combs through price ratios and mathematical relationships between companies or trading vehicles in order to divine profitable trading opportunities.

During the 1980s, a group of quants working for Morgan Stanley struck gold with a strategy called the pairs trade. Institutional investors and proprietary trading desks at major investment banks have been using the technique ever since, and many have made a tidy profit with the strategy. It is rarely in the best interest of investment bankers and mutual fund managers to share profitable trading strategies with the public, so the pairs trade remained a secret of the pros (and a few deft individuals) until the advent of the Internet.

Online trading opened the lid on real-time financial information and gave the novice access to all types of investment strategies. It didn't take long for the pairs trade to attract individual investors and small-time traders looking to hedgetheir risk exposure to the movements of the broader market.

Pairs trading has the potential to achieve profits through simple and relatively low-risk positions. The pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss. The goal is to match two trading vehicles that are highly correlated, trading one long and the other short when the pair's price ratio diverges "x" number of standard deviations - "x" is optimized using historical data. If the pair reverts to its mean trend, a profit is made on one or both of the positions.

Tradebot


Kansas City Business Journal - January 14, 2005 by Charlie Anderson Staff Writer



A flat-screen computer announces: "Crank the volume!"
The traders on the floor sit silently, clicking their mouses. If you were expecting "Boiler Room" or "Wall Street," you'd be wrong. Jeans and T-shirts are favored over Gordan Gekko-esque cufflinks.

But Gekko would be proud: Tradebot Systems Inc. trades an estimated 3 percent to 5 percent of all shares exchanged on the Nasdaq market each day, founder and CEO Dave Cummings said.
Tradebot trades 50 million to 100 million shares a day. Anywhere from 1 billion to 2 billion shares trade daily on Nasdaq.
That means billions of dollars worth of equities pass through Tradebot's software-driven trading system each day. At any given time, you might walk in and see that the firm has traded 20 percent of Yahoo! Inc.'s daily volume.
The stock doesn't stay for long: Tradebot starts each day holding no shares and ends each day holding no shares. It makes profits in the fractions of pennies on each share by quickly buying and selling. When all the gains are added up, you might have a $50,000 day, Cummings said.
"It's day-trading on steroids," he said.
Tradebot began as a software project in 1999. Today, it might be Kansas City's most fascinating company.
Trader Andy Vos joined Tradebot two years ago, but he still hasn't shaken that amazed look people get when they first walk through the doors.
He's seated amid 24 computer screens, each of which flashes hundreds of numbers. Vos points out the one that matters: a line chart that shows he's made more than $5,000 after rapidly buying and selling millions of shares of stock.

SOURCE: Kansas City Business Journal
AUTHOR: Charlie Anderson, Staff Writer

Originally published in the June 24, 2005 print edition of the Kansas City Business Journal.

Exchange will take on Wall Street
Electronic network will compete with NYSE, Nasdaq plans
The founder of Tradebot Systems Inc. is launching an electronic stock exchange in a bid to inject competition into the rapidly consolidating industry.

BATS Trading Inc.
BATS is an acronym for "better alternative trading system" -- is in the development stage, but Tradebot CEO Dave Cummings said he wants to launch the electronic communications network early next year "There's room in the marketplace," he said.

Tradebot is one of Kansas City's most cutting-edge technology companies. Based in North Kansas City, it trades about 50 million to 100 million shares of stock a day, including a sizable daily volume of stocks such as Microsoft Corp., Yahoo! Inc. and Google Inc.
That makes Tradebot one of the largest customers of the big electronic communications networks, such as Archipelago Holdings LLC.

ECNs are electronic exchanges that match stock traders through fast Internet connections.
On April 20, Archipelago announced plans to merge with the New York Stock Exchange. Shortly thereafter, Nasdaq announced merger plans with another large ECN, Instinet Group Inc.
Cummings said he sees the news as an attempt by the exchanges to be the only game in town for traders.

"I believe market share should be earned, not bought," Cummings said in a statement on the BATS Trading Web site.
Joe Ratterman, the former chief information officer of Lenexa-based LabOne Inc. who joined Tradebot last year, will be COO of BATS Trading.
"One of our primary motives is to keep competition alive," Ratterman said.

News of Cummings' plans have created buzz on Wall Street, said Adam Sussman, a senior consultant at The Tabb Group in New York. The Tabb Group provides research and consulting services to the financial industry.
Sussman said BATS Trading is the first plan for a new ECN to come out in the wake of the mega-mergers announced by the NYSE and Nasdaq.
Ratterman said a handful of electronic trading firms like Tradebot plan to build ECNs.
Tradebot makes profits in the fractions of a penny on each trade using a software-driven trading mechanism.

BATS Trading will license Tradebot's software to create the trading platform.
Sussman said BATS Trading can be successful if it undercuts the pricing of the larger ECNs.
"You disrupt the profitability of the larger ECNs and force someone to buy you to take you out," he said. "If I were starting an ECN, that's what I'd do."

One of the biggest challenges facing ECNs is getting enough traders in the system to make it worthwhile for large-scale trading of stock, said Laura Tuttle, an assistant professor at the University of Kansas School of Business. A former Nasdaq employee, Tuttle's research has included ECNs and Tradebot's technology.

Tuttle said Cummings has an advantage because he can pump Tradebot's huge volume into the system.
"I can't imagine that there's anyone out there more qualified to launch a trading platform than Dave," she said.
Cummings said he will finance the venture personally for at least the first six months of development. After that, he said, he will look for outside investors, hire a management team and open an operations center in the New York-New Jersey area.
"I really like building a company, taking it from zero to 30 people," Cummings said.

Ratterman and Cummings said they can build an ECN for less money than Archipelago did
Archipelago piled up losses of $39 million, $38 million and $35 million in 2000, 2001 and 2002, respectively.
Cummings said times have changed.
"That was a dot-com era," he said. "We think we can do it for a few million dollars."