Pair Trading Guide
Pair Trading Educational Course – Part 1
Contrary to popular belief the market has logic to it. The market is efficient most of the time, which is stocks are priced accurately according to all the known and forecast information. The truest logic running through markets is that of relative value, all assets are worth something in relation to something else. Take gold for example; when you buy gold you are going short the dollar too. Stocks, when you buy stocks you are going short cash. Stocks, bonds, commodities & currencies are all inter-related markets with different themes running through them at any given time. The price of oil directly affects the profits of oil companies, hence a correlation between oil futures and oil stocks. Generally the stock market is a forecasting barometer for how the economy will perform over the next 6-12months. That’s why stocks markets always bottom before the economy does and vice versa for topping. Consider the market a big voting machine that represents the collective forecasts of every market participant. Then within the market are different industries, they are priced for their expected growth rates too, then finally within each industry stocks are priced for their individual growth prospects. Generally speaking stocks within the same industry have similar valuations; if one stock is expected to grow a lot more than another stock you will find however it has a higher valuation, a higher P/E. The stock market as a whole is affected by interest rates set by central banks, thats why they respond dramatically to changes in the expected interest rates. Many stock valuation models incorporate the risk free rate of return on government bonds. If bonds are yielding 10% stocks have to be growing significantly for them to be cheap relative to the risk free rate of return. If interest rates are 1% stocks don’t have to be so cheap to seem like a good buy. As you can see the markets are all connected and related to one another in some
Contrary to popular belief the market has logic to it. The market is efficient most of the time, which is stocks are priced accurately according to all the known and forecast information. The truest logic running through markets is that of relative value, all assets are worth something in relation to something else. Take gold for example; when you buy gold you are going short the dollar too. Stocks, when you buy stocks you are going short cash. Stocks, bonds, commodities & currencies are all inter-related markets with different themes running through them at any given time. The price of oil directly affects the profits of oil companies, hence a correlation between oil futures and oil stocks. Generally the stock market is a forecasting barometer for how the economy will perform over the next 6-12months. That’s why stocks markets always bottom before the economy does and vice versa for topping. Consider the market a big voting machine that represents the collective forecasts of every market participant. Then within the market are different industries, they are priced for their expected growth rates too, then finally within each industry stocks are priced for their individual growth prospects. Generally speaking stocks within the same industry have similar valuations; if one stock is expected to grow a lot more than another stock you will find however it has a higher valuation, a higher P/E. The stock market as a whole is affected by interest rates set by central banks, thats why they respond dramatically to changes in the expected interest rates. Many stock valuation models incorporate the risk free rate of return on government bonds. If bonds are yielding 10% stocks have to be growing significantly for them to be cheap relative to the risk free rate of return. If interest rates are 1% stocks don’t have to be so cheap to seem like a good buy. As you can see the markets are all connected and related to one another in some