L/S Pair Trade
I have a HF case study to pitch a L/S pair trade. I've never encountered this before so had some questions
- I know a pair trade is 2 stocks within the same sub-sector (Pepsi/Coke, CRWD/S, etc) - however, I also ran some names through a pair trading web lab and for a lot of names I thought were cointegrated, they statistically seem not to be with a low p-value (Engle-Granger cointegration test). (maybe something is wrong with the websites software). How do you go about picking a pair that makes sense from a statistical point of view?
i.e. ESTC/ DDOG, where the p-value I'm getting is 0.6.
2. Is that something they would care about? I.e. the whole statistical modeling side of if its actually a pair vs. just picking 2 competitors within a subsector and pitching one long and short.
3. Is this more of a short term bet? I.e. I think we should buy stock A today and short stock B and given earnings in 1 months, we should close our position with a ~3 month price target?
You have overcomplicated this. Your pitch shouldn’t be around a statistical test (although it’s useful to do that for other reasons). You should pitch the names against each other due to fundamental reasons around the narratives and valuation/earnings.
Pick 2 names in the same sub sector. Think about the bet you want to make…are you wanting to trade 2 American sportswear brands and take a bet on which is fundamentally better/has more earnings upside in the near term? Or do you want to bet around product mix and trade the idea that one’s product mix is slightly higher margin and levered to some faster trends etc.
I trade a lot of European stocks for my pod, and more often than not a lot of my ideas (not all are pairs mind you) end up betting various consumer/macro profiles in eurozone economies against each other.
Agreed. L/S pairs and quant pairs are 2 different things. They wouldn't expect you to create a pairs trading strat for an interview.
Yeah you don't need to include the statistical analysis component, for L/S that's not what you're going to be focusing on to make a call in most seats unless you're quant heavy. IMO you're better off pitching it as an RV pair trade if this is a more fundamental L/S-type role. Echoing great advice I received from when I was interviewing that was super helpful:
You'll want to look for a concrete industry catalyst, form a view on it, and then express that by pitching a long and a short that have mismatched sensitivity to it.
Made up catalyst: I think Capex on AI infra is going to slowdown in 2Q26.
Analysis: Given the lead times in the supply chain, what's going to get impacted first and what's going to get impacted last? Hyperscalers might get hit first (AMZN, MSFT, GOOGL), then data center networking solutions (ANET, SNPS), then chip designers (NVDA, ARM, AMD, QCOM), then fabs/foundries (TSMC, INTC), then maybe the companies that provide power infra (ENB, KMI). If I make pairs across that entire stack and then dig into the idiosyncratic risks I can choose which pair makes the most sense to reflect my view while also making sure I'm investing in companies that are likely to see the greatest divergence in performance from a fundamental standpoint if the catalyst doesn't play out.
Sizing is a different beast, wouldn’t touch that since there are a ton of constraints and factors that need to be incorporated based on book composition.
In this example you’re mostly making money on the short since you're talking about a negative catalyst. The short should get hit harder from a slowdown while the long should be more stable or have some factor that allows them to outperform relative to everyone else. However I suggest looking at the whole supply chain since short NVDA, Long ARM would probably be a dangerous bet.
The challenge with finding good pairs is that both the long and short have to independently have merit so that even if your catalyst thesis doesn’t play out, you’re positioned correctly based on fundamentals.
Generally the easiest way is to really focus on the next 2-3 quarters and dig into the set up for each name. That way you have a “long term” catalyst in the slowdown but are using the near term set up for the next quarter to position yourself and build more conviction. Again, I’d pick a less complex view than what I said since there are too many factors that could blow up.
Maybe take a view that new business starts are going to take a hit or hiring will slow and then express that on a payroll/HCM software pair. If you’re doing special sits you could even do something like the Paycor / Paychex Acq.
Finally moved over to HF?
Where I'm at now is more of a multi-strat investment firm than anything resembling traditional L/S and it's not structured as a HF. But I recruited for L/S TMT at both pods and SMs for ~9mos and was successful in getting through a couple of processes so I've got a few nuggets I hope are helpful to folks.
Thank you - this is a super helpful overview.
Would you say that Topicus/ Lumine are pair trades?
Both are Constellation Software spin-outs doing software roll-ups but Topicus operates exclusively in Europe while Lumine mainly acquires companies in Canada/N.A. They seem to trade similarly in terms of movement and given CSU still holds a sizeable stake in both, but operate in separate continents.
Happy to help!
I would point you towards step 1 - developing a thesis with a clearly defined catalyst. Realistically any 2 companies within a sector can be a pair trade but are they a good pair trade? Classic "it depends" scenario.
If there's something in the underlying fundamentals that makes you think one will outperform the other then for sure there's a pair trade to be done there. But what's going to showcase your investor mindset/acumen for thinking through a thesis and picking out the alpha will be the thesis development around why you chose them which (IMO) is best anchored by some sort of catalyst in the near-to-mid term.
In your example I'd want to know - what's different between the EU and NA software markets? Which is growing faster and why? Who is building better products? Who is building products faster? Who is better at monetizing? And why for each of those. There'd have to be some differential view between the geographies for it to make sense as a pitch IMO. But then I'd want to find a catalyst somewhere - maybe IT spend is dropping faster in NA than EU because NA companies are adopting AI faster and in-housing more stuff they would've previously bought from a 3rd party. Or maybe the reverse - quicker adoption of AI into the development cycles of NA software companies means greater efficiency (faster feature development, lower engineering expenses, etc.) and so you think that NA software is the better long. It all depends on what research you do/data points you provide to back up your thesis's assertion.
Even if your catalyst is wrong (either it doesn't happen or the opposite happens) that in and of itself won't necessarily work against you because that happens all the time - no one can perfectly predict the future. If you worked through the fundamentals properly you should still be positioned in the underlying companies so that you are "correct" in terms of outcome (i.e. a profitable trade). It's the additional layer of analysis around a catalyst and tying that back to said fundamentals that shows the PM how you think about the companies which is what they're going to care about more than you being right on that isolated pick. Anyone can get lucky and be right, but if you show rigorous analysis in your thought process that's what will convey some level of confidence in you being able to be right more often and safety for the inevitable times you will be wrong.
When I was first interviewing for L/S and got to the "pitch me a trade" stage I only suggested pairs based on the fundamentals and while that sometimes got decent feedback (though a few were utter shit in hindsight), what got me better results in processes and more positive feedback was layering in the catalyst component to convey to the PM "why this matters now". It's harder and takes more time, but it gets easier with practice just like anything else.
To all the HF hopefuls THIS!!! If you can incorporate this into your pitches it will be 1000x better received than 90%+ of candidates we get.
How would the paychex paycor acquisition constitute a pair trade?
It's more of an easy example of one that could've been done rather than one you can do now that it's closed, it's just special sits/merger arb. You're positioning across the pair based on whether or not you think the deal will or won't close, and if it does close whether at, below, or above terms so you can capture the spread post-announcement but pre-close.
What geography/US region is the fund in?
You're confusing a fundamental pair trade (which is what they want) with a quant/statistical arbitrage pair trade.
Broadly speaking how large are the models you would build for this type of trade? Currently reading "Financial Modeling for Equity Research" and am curious how the model in this book stacks up to the real world. How long does it take to get from the idea phase to IC approval? Outside of the company specific models, how do you model trends in a sector?
Imagine an IC meeting for a pair trade that lasts on average for a quarter lol
There’s so much wrong with this question that I don’t even know how I’d start clearing things up for you
You mean to tell me you guys DON'T trade earnings by committee? Aw gee willikers... lol
For a case study, most interviewers care that you can justify why one stock should outperform the other. Showing some statistical support is a bonus, but being able to articulate the fundamental or thematic reasoning (different growth profiles, margin expansion, market share, etc.) is more important.
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