By Douglas S. Ehrman

John Wiley & Sons Inc. 2006

249 pages, $95

Reviewed by Nelson Freeburg

Pairs trading is a market-neutral investment strategy that attempts to take advantage of temporary anomalies between related stocks. Ehrmans text, though not an exhaustive treatment of the subject, comes as a helpful introduction. Early on he examines the factors necessary to assure market neutrality, a key imperative in pairs trading. It is not enough to allocate equal amounts of capital to the long and short sides of the trade. To eliminate directional bias you may have to select matched assets for beta neutrality, sector neutrality and market-cap neutrality; this is good stuff as is his advice on execution tactics.

Ehrman describes fundamental and technical approaches and a blend of the two. He clearly favors technicals, in the end recommending a dominant technical screen with a fundamental overlay.

Ehrman favors three technical tools to set up the pairs trade. The first is a simple moving average of the spread between the paired stocks. The second is a Bollinger Band analysis of the spread, furnishing dynamic overbought and oversold levels. The third is an RSI of the spread, also yielding overbought and oversold levels. In essence, when the spread reaches an extreme high according to the consensus of these three indicators, you go long the weaker stock and short the dominant stock.

These ideas make sense, but fuller documentation of performance would be helpful. For instance, he writes that any contact with Bollinger Bands is likely to set up a good countertrend trading opportunity. Anyone who uses Bollinger Bands to trade individual equities or commodities knows you would get hammered if you faded every tag of the upper or lower bands. Maybe the countertrend setup is more reliable in pairs trading than outright trading, but Ehrman offers no systematic evidence to support the claim.

The Handbook of Pairs Trading is a worthy effort by a gifted analyst. Yes, Ehrman commits a couple of literary no-nos. We learn of a very useful indicator for pairs trading only to find it is proprietary and cannot be discussed. And he promotes his paid advisory service. But Ehrman is a skilled writer and I would welcome a more comprehensive and detailed treatment of his investment strategies.

Nelson Freeburg is editor of Formula Research, a financial letter that builds and tests quantitative timing models for stocks, bonds and commodities. It serves systematic traders and institutional money managers in 27 countries.