As Pairs Trading Evolves, Hedge Funds Grapple with Complex Workflows

April 22, 2024 | By: Ivy Schmerken

Many multi-strategy hedge funds are recognizing the need for an integrated OEMS.

Pairs Trading Workflow Linked Orders Image_

With the rise of multi-strategy hedge funds, pairs trading has become a popular investment technique for generating returns in a market neutral manner. But the trading and compliance workflows add a magnitude of complexity beyond trading a single instrument and the technology requirements have intensified. 

A hedge fund manager might run a statistical arbitrage strategy across global equities, futures-hedged options pairs, or convertible arbitrage, which is currently a hot topic among clients, said Jose Cortez, CFA and Vice President of Buy-Side OEMS Sales at FlexTrade. Some firms will have a pod executing one or two of those pair strategies, he explained. Potentially, some firms may have portfolio managers trading names in a pair that are also held and traded in another portfolio manager’s (PM’s) book.  

This means proper order making is critically important,” said Cortez, referring to the short-sale requirements under SEC Reg SHO. 

As a result of the evolution toward more sophisticated strategies across multiple asset classes and different currencies, pairs trading now demands instantaneous access to short locates, order-marking, allocations, and the compliance engine – the technology requirements have increased. 

In the past, hedge funds had access to pairs trading strategies through the execution management system (EMS) and then staged the buy-and-sell orders into their third-party or proprietary inhouse order management system (OMS). Today, hedge funds want a seamless integration via the OEMS to manage the complex relationships between securities and different asset classes. 

Over the last couple of years, FlexTrade has brought the order life cycle functionality into “the EMS pairs dashboard” where the FlexTrade algorithms and smart order router (SOR) reside. All the order life cycle engines of FlexONE— including security master, order marking, short locates, compliance, and fund/prime brokerage allocations — have been integrated into the pairs trading framework. 

With this additional integration work completed for FlexONE clients, the OEMS brings everything into the trader’s workflow on one platform. “Instead of staging individual legs first, the trader can use our OEMS pairs framework to size a deal, or pair, and instantaneously run through prime/allocation logic, pre-trade compliance, as well as order marking, and then route each leg to different brokers,” said Cortez, noting that traders are using FlexTrade’s proprietary algorithm for full control over execution. 

Pairs Trading Algos

When hedge funds execute their pair strategies, they use algorithms to slice orders into the market to minimize market impact. 

FlexTrade offers a global, multi-asset, multi‐currency pair and spread trading algorithm for two instruments. In a pair trade, two instruments are traded in equal currency units (or a ratio of currency units) and a “spread trade” refers to a trade in which the two instruments are traded in a ratio of shares or contracts. 

Many unique algos for options have been developed by FlexTrade such as delta-adjusted pairs trading, which consists of an option and an offsetting index future, and others with options such as volatility-adjusted pairs as well. 

Hedge funds research their ideas for pair trades based on their own models or other third-party analytics. In addition to sizing and creating pairs orders from the user interface (UI), they can enter their lists of pair trades through a bulk upload or application programming interface (API). 

It’s the role of the PM/trader to understand the relationship between two different instruments and create a thesis that drives sizing of each leg of a pair, explained Cortez. 

Inherent Linkage Between Orders 

A key component of pairs trading is creating an inherent linkage between two or more orders which contain both a long and short position, explains Cortez. “Having that linkage maintained and monitored and doing tasks like running allocations across both legs is critical to the strategy.” 

When building a pair trade, the OEMS creates a linkage between the legs, which enables proper tracking and management of the order.  Compliance can be run at the pair or package level, or on the individual legs, allowing for contingent workflows between the two legs. 

 “Even if one leg is held up in compliance or awaiting a locate and the long order is on the blotter, the OEMS Is making sure the trader can’t execute the long leg- until its counterpart — the other part of the pair — has gone through compliance and all of the checks.” The idea behind pairs trading is that both legs are traded together to create a netted exposure between the two legs. If a trader executes the first leg, without getting approval for the second, this defeats the intended purpose of the investment idea generated by the PM and could leave the firm with an outsize risk on the books. “Your pair trading strategy is about netting these exposures off and trading them in tandem,” he said. 

“Think of pairs trading as contingent orders – one leg is contingent on the other, and the linkage ensures the contingency is maintained,” continued Cortez. “But it’s important to note that a pairs trade does not go through a different order life cycle. A pairs trade goes through the same order life cycle as a single trade,” he explained. 

These strategies leverage FlexONE’s pairs dashboard, a dedicated window which the user can dock within the OEMS. Here, the trader can visualize the progress of the execution between the buy and sell legs for a merger arbitrage deal. For example, the pair trade might be 63% done on the buy and 65% on the sale. “It’s important for the trader to watch the imbalance between the two legs,” emphasizes Cortez. “If one leg is more liquid than the other, that has the risk of getting executed more quickly and getting legged on the other side,” said Cortez. 

Basket Pairs Trading 

To address the imbalance, the algorithms will manage the relationships based on user input. There’s a button, the trader can click to enter orders into the market as quickly as possible, Cortez noted. Or the trader could highlight the pair and hit cancel or pause, which could happen with a merger arb deal when there is news coming out at midday. “It won’t completely cancel the orders, it will pull out the slices from the algo that the trader is sending out until the trader is ready to un-pause or replay the trade,” noted Cortez. 

Some strategies involve executing ETFs against the underlying stocks or a stock index future or options contract and involve rebalancing a global portfolio. In these instances, pairs trading can also be set up at the basket level to execute a large list of instruments. 

In addition, standard compliance checks will scan the basket for adherence to investment guidelines, so if non-US stocks are not allowed, and there is a Canadian stock trade, the trader will be notified. Alternatively, when baskets are denominated in different currencies, say securities denominated in Sterling vs. Euro, the system automatically balances both executions in the selected currency. Automated hedging of currency exposures can be handled in real time, based on rules set by the trader. 

The Future

With the growth of multi-strategy hedge funds, shops have diversified into a variety of pair trading strategies, such as risk arbitrage or convertible bond arbitrage, handled by different pods. But the workflows associated with pairs trading — executing linked securities trades, arranging short locates, running compliance and allocations — are complex and can pose challenges if undertaken on separate systems. The future is about simplifying workflows and driving efficiencies. Many hedge funds are turning to the OEMS to lead that charge. 

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