How I Construct a Pair — Step 1: Screening for Stocks

If you want to find correlated pairs to trade you need to find good candidates.  A good starting point is screening for similar stocks.  Here are a few basic criteria/categories to consider when constructing a screener.

  • Industry and Sector.  Narrow down stocks by the business they are in.  This is a primary step to ensure your selections have a common sense reason to trade together.
  • Share Price. Commission structure, available capital, risk tolerance, and trading style will dictate whether you want to trade $10 stocks or $100 stocks.  I tend to choose higher priced issues.
  • Volume.  Liquidity is a major consideration when selecting pairs.  You must be able to clear your trades with ease.  Some stocks also get a large liquidity premium in normal times and especially in times of market stress.  I like stocks that trade a minimum of 500k per day on average.
  • Foreign/Domestic Exposure. Where a company earns its money, operates, and pays its taxes is important.  One company may earn in Euros and one in Aussie dollars.  Not all companies do a good job of hedging currency exposure.
  • Index membership. Index membership can imply a premium.
  • Market cap. Merger risk is a significant consideration if you hold positions overnight.  Lower market cap stocks are more at risk of being bought out, and in many cases at a premium to where they currently trade.  Are your shorts an acquisition target or your longs shopping for acquisitions?  Do you want to come in on “Merger Monday” with a 40% divergence in one of your pairs?  Merger arb is a separate discussion.

Here is a quick screen I did for Canadian Banks:

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