Pair Trading - Collaboration in Finance
Pair trading is a technique to improve the productivity and quality of stock trading (or any type of financial trading, e.g. commodities). In pair trading, two traders share a single workstation. The trader at the keyboard (usually called the driver) actively trades, while the second trader (called the observer or navigator) is reviewing, advising, thinking through problems and generally sanity checking the first. These two roles switch on a regular basis (e.g. every ½ hour). The pairs also swap partners every day.
Pairing is one of the most valuable techniques you can bring your business, yet it is initially counter intuitive. It is hard to convince management that pairing will do anything but double your costs. In actual fact, most empirical studies show a significant increase in quality for a small (15-20%) cost overhead as compared to individuals working independently.
Some history about pair trading. This is an idea that I, and some of my clients in the finance sector, have been developing and experimenting on for a number of years. Pair Trading is heavily based on the agile technique of pair programming, in which computer software is written in pairs. This has proven successful in many organizations. It is claimed (with some empirical support, though not entirely conclusive) that the ~15% overhead is actually less than the long-term cost of poor decision making (and in the case of software, defect resolution and maintenance).
So why would you do this? Let’s look at some of the advantages and pitfalls:
- Higher quality trades = less risk and more money; this one is obvious. With two people working together, market conditions can be better assessed and industry knowledge pooled, leading to better, less biased, trades.
- Skills & knowledge transfer and adhoc training; by continuously working together, traders will learn each other’s domain and trading tactics. By changing pairs daily, all traders will get the chance to work with and learn from each other.
- Shared knowledge of industry and companies; similar to 2 above, when pairing, traders will share industry insights and awareness of specific and valuable companies in the industry.
- Justifiable trades; a key measure for successful pair work is the ability for the pair to “trade out loud.” This leads to clearer articulation of the complexities and justifications of a trade and the often subconscious details that inform the decision.
- Resilience to interruptions; a final advantage is the ability for the pair to focus. Or as I like to put it, less Facebook time.
Also understand that the advantages are going to be different depending on the type of pair. For example, an expert-novice is going to have a greater skills transfer than expert-expert or novice-novice. That being said, when you are rotating pairs, it is valuable to have all combinations.
Disadvantages and pitfalls
While it can be described fairly easily, pair trading is not the easiest thing to learn.
- It costs more in the short term; while most empirical evidence shows higher quality work, these same studies show a 15-20% increase in immediate cost. The impact of that on the team, and the ultimate effectiveness of pair trading, depends on how long it takes for the improved trades to pay off.
- It’s a social skill that takes time to learn; it can take weeks for pairs to learn how to communicate and productively collaborate. Don’t expect them to sit down together and be more productive than their non pairing peers immediately.
- It requires both traders to be actively engaged; the role of navigator is just as active and intense as the role of driver. The value and benefit of pair trading is only realized when both traders are participating. A key indicator of a poor performance pair is silence; there should be an ongoing hum of communication.
- Pay and bonuses; while pay can be commensurate with experience; bonuses need to be shared across the team. As everyone is working closely together it is very difficult (though not impossible) to differentiate performance.
I hope this gives you some ideas on how you can bring adaptability into your workplace. If you are unsure, experiment. Set up one team as a pair trading team and measure their performance against their non-pair peers. If, after a couple of months, they are outperforming the other teams then you know you are onto a winner.
- Not to be confused with a Pair Trade