High risks accompany financial transactions. This is why professional traders have always looked for a way to minimise their risk. One of the strategies aimed at diversifying risks is pair trading.
Pair trading is a market-neutral strategy that involves trading a pair of related financial instruments on the stock exchange. This trading system is suitable for all types of stocks, commodities, and futures markets. Trading in pairs allows you to reduce risks significantly compared to a directional trading strategy.
The very concept of market-neutral trading means that a trade’s profit is not directly dependent on a single instrument’s movement.
How Does Pair Trading Work?
Pair trading has the potential to profit from simple and relatively low-risk positions.
The basic principle of pair trading is to identify a pair of securities with a high degree of correlation, one of which has significantly increased or decreased in price relative to the other, after which there is a short sale of the overvalued security and the purchase of undervalued security. Thus, a neutral portfolio is formed, the profitability of which will depend not on the general direction of the market movement but the future ratio of the value of one security to another.
Pair trading is based on related assets that have the same dependencies or basis, for example, the price of oil and the value of oil stocks. If quotes for a specific commodity fall, the value of shares linked to them may fall disproportionately, i.e., a fall in the oil price. The shares of oil companies may rise in the short term.
How to Find Correlated Stocks?
In pair trading, positions are opened simultaneously for two instruments. The main selection criterion is the presence of a correlation between assets.
The correlation of stock assets is the ratio between the price movements of two stocks in the same sector of the economy or stocks with other asset classes such as bonds, indices, futures, options, investment funds.
Determine their average price to find the correlation between the two stocks. You need to select a time period and add up each stock’s daily price for that period and divide by the number of days in the selected period. This will determine the average price. Then you need to calculate the daily deviation for each stock.
The variance is the price of a stock on a specific day minus its average price. You need to do this calculation for each day in the time period that you are measuring.
It is advisable to use stock screeners to select correlated assets.
Having two correlated assets, a trader opens a short position on one of them and a long position on the other.
Thanks to this approach, even in an extremely unfavourable market situation, a trader minimises losses over a long period of time with profits on short periods and vice versa.
The formation of an investment portfolio, including stocks with a high level of correlation, allows you to diversify your portfolio.
Advantages and Disadvantages of Pair Trading
Pair trading might seem like a simple strategy at first glance. But knowledge in the field of statistics and a clear understanding of the term ‘correlation’ play an essential role, as does the ability to carefully select both the instruments themselves in pairs and choosing the right moment to enter.
Due to the rare entry signals and the lack of tools for complete protection against losses (for example, stop losses), traders should be very careful when trading using this strategy, observing high restraint and trading discipline.
| Advantages | Disadvantages |
| Pair trading is suitable for those who know from experience how to analyse indicators. There is no need to think about the direction of movement of the value of any one asset. | Calculations require special software. |
| If you choose the right financial instruments, the results will be impressive and fairly stable. | Finding correlated pairs manually is very time-consuming. |
| This trading strategy applies to all types of markets and on all timeframes. | The strategy requires strict adherence to risk management. |
| This strategy is market neutral. It doesn’t matter where the market goes; only the ratio of the cost of the instruments matters. This allows you to exploit market inefficiencies and reduce trading risks. |
Correlation between assets is temporary. Therefore, you should not dwell on one pair of assets for a long time; you must constantly search for pairs suitable for statistical trading.
Pair trading principles
Pair trading is a medium-term strategy.
- Opening two opposite positions. Events can develop in different ways, so one trade may go to profit and the other to zero or negative. With the first option, you can complete the contract with a plus or a minus if the uncorrelation continues. With the second option, you can wait for the correlation to recover and close deals, fixing a minus, or additionally enter the market.
- According to another model of behaviour, the contract is concluded for only one asset of the pair. This method is not suitable for beginners, as the risks associated with the entry point and the object’s choice are high.
A Simple Strategy for Pair Trading
Traders manually search for correlated assets and then analyse the discrepancies. It can show how far the quotes have moved away from each other in the past. Average discrepancies are calculated from these data, and trading decisions are made on them.
When the entry point is found, the trader makes two deals, the rising asset is sold, and the falling asset is bought. At the moment, when prices cross, positions are closed.
This pair trading strategy is considered one of the simplest. But when using it, you can gain a good win.
- You can use the correlation coefficient, which ranges from -1 to +1, to select a pair of instruments. At a parameter value of +1, assets move synchronously, while at -1, an inverse correlation is observed. It is optimal to choose instruments with a correlation coefficient of 0.75-0.95. There must be obvious patterns on the chart of the traded spread.
- At the next stage, the volume of positions of each instrument for trading is calculated. This can be done using the ATR indicator.
- The trading chart is obtained by subtracting the day’s close prices from the same 10-day average. The levels for making trades are determined based on calculating the average standard deviation of prices for the last three years.
- The strategy involves the simultaneous purchase of one instrument and the sale of another in a 2:1 ratio. You need to wait until zero levels are reached to fix the profit.
Pair trading is based on identifying the patterns of behaviour of 2 instruments on historical data. The degree of correlation of assets over time can change under the influence of economic factors. Unlike direct arbitrage, there is no guarantee that the price ratio of a pair of trading instruments will return to the historical level. Therefore, the use of this strategy requires strict adherence to risk management. It is necessary to determine in advance the levels upon reaching which the position will be closed with a loss in the event of unfavourable developments.
Experienced traders use pair trading as one of their strongest tools to achieve profits with minimal risk. This strategy is considered neutral and allows you to act in different market conditions.
But do not forget that trading two assets does not guarantee income. Whatever analysis is carried out, the relationship can break at any time. Here you need to take into account all the risks and have a clear action plan.
Read more about him by visiting his LinkedIn profile or contact us directly to learn more about the team.Our Author:
Adam Jarfjord is a Swedish day trader, investor, and copywriter. He works as head of content at BullMarketz.com and has been providing editorial content within the financial sector for more than 5 years.
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