Trading Techniques  |  MAR 2001

Pairs Trading by Stephane Reverre

Exploiting Closely Related Stocks Pairs Trading Some relationships in the stock market make for very profitable trades. by Stephane Reverre The arbitrage of Royal Dutch (RD) and Shell (SC) is a popular one on Wall Street because it is a classic example of a pair-tradingÝ model, a strategy that involves trading two stocks — one long, the other short-term based, on the assumption that their prices follow an identifiable recurrent pattern — backed by a strong relationship between the companies. Essentially, RD and SC are opposite sides of the same coin; they both derive their revenues from a fixed partition of the income generated by the entire corporate group. Indeed, they are linked by corporate charters stipulating that 60% of the income received by the group will be allocated to RD, while the 40% remaining will be allocated to SC. Therefore, it is possible to extract an exact relationship between the two stocks’ prices (see sidebar “Pairs relationships”).

by Stephane Reverre