Pairs Trade: Definition, How Strategy Works, and Example

what is pairs trading

Fortunately, using market-neutral strategies like the pairs trade, investors and traders can find profits in all market conditions. The long/short relationship of two correlated securities acts as a ballast for a portfolio caught in the choppy waters of the overall market. Good luck with your hunt for profit in pairs trading, and here’s to your success in the markets.

what is pairs trading

A pairs trade strategy is best deployed when a trader identifies a correlation discrepancy. Relying on the historical notion that the two securities will maintain a specified correlation, the pairs trade can be deployed when this correlation falters. Pairs trading is a popular strategy, but like all strategies, it is not without risks and it is not successful all the time.

Pairs trading strategy

Look for ETFs, futures, non-stock assets and other derivatives. Choosing 2 assets, which are very different, that happen to move together for a short period and assuming that will continue. Imagine if we identified and are trading 20 pairs independently. For futures, the dollar value per unit of movement is usually different for different future contracts. Maybe some of them don’t move as expected on Mondays, December or some other time-based conditions.

what is pairs trading

Historically, the two companies have shared similar dips and highs, depending on the soda pop market. If the price of Pepsi rose to close that gap in price, the trader would make money on the Pepsi stock, while if the price of Coca-Cola fell, they would make money on having shorted the Coca-Cola stock. Pairs trading is a strategy that tends to use statistics to identify relationships, assist in determining the direction of the relationship, and then ascertain how to execute a trade based on the data. The pairs trader attempts to capitalize on market imbalances between 2 or more financial instruments, such as stocks or funds, in anticipation of making money when the inequality is corrected. A pairs trade in the futures market might involve an arbitrage between the futures contract and the cash position of a given index. When the futures contract gets ahead of the cash position, a trader might try to profit by shorting the future and going long in the index tracking stock, expecting them to come together at some point.

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It seeks to maintain neutrality by keeping the exposure on each trade identical. Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. You could sustain a loss of some or all of your initial investment and should not invest money that you cannot afford to lose. Below is a weekly chart of the price ratio between Ford and GM (calculated by dividing Ford’s stock price by GM’s stock price).

Pairs trading has the potential to achieve profits through simple and relatively low-risk positions. The pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss. To illustrate the potential profit of the pairs trade strategy, consider Stock A and Stock B, which have a high correlation of 0.95. The two stocks deviate from their historical trending correlation in the short-term, with a correlation of 0.50. The strategy has reduced directional risk, since a trader that goes long or short faces the possibility that the market will move in an opposite direction to that of the trade.

  1. Generally speaking, the short side of a trade should be executed and filled before the long order is placed.
  2. Option traders use calls and puts to hedge risks and exploit volatility (or the lack thereof).
  3. Meanwhile, Brent and WTI can also be positively correlated in the commodities space, while many commodities tend to move inversely to the price of the US dollar.
  4. However, if you understand the assets well, you can choose and time your trades better than others.
  5. The beauty of pairs trading is that it can be utilized by both fundamental investors and technical analysts.

They are both wandering around, but they are both independent so there is no meaningful connection to their movements. However, a man walking his dog is an example of correlated movement. The dog may wander away from the man, but it will eventually come back. The man and his dog are correlated, and the times when the dog moves away from the man are examples of the ratio between two markets becoming stretched. To identify this, the trader can use Bollinger Bands, which are indicators that contain upper and lower bands that are two standard deviations from the ratio’s price. When the ratio hits the top or bottom Bollinger band, then a trading opportunity is created.

Step 2: Chart the 2 assets

It can also be referred to as market neutral or statistical arbitrage. Pairs trading was first introduced in the mid-1980s by a group of technical analyst researchers that were employed by Morgan Stanley, the multinational investment bank and financial services company. The pairs trade strategy uses statistical and technical analysis to seek out potential market-neutral profits. To devise a pairs trading strategy, a trader will need the price data for the two markets, and then create a ratio (one market’s price divided by the other). When the ratio between the two moves outside its normal range then a trading opportunity is created. Pepsi (PEP) and Coca-Cola (KO) are different companies that create a similar product, soda pop.

We look at pairs trading – what it is, how investors can implement it as a strategy, and both the positives and negatives of using it. You don’t need your pairs trade to return huge profits per trade. You will know when to enter the trade and when not to, even as the 2 assets diverge and everyone else is entering the pairs trade.

Moreover, the average price movement of the different future contracts are different too. Thus, we need to account for these to make sure the size our bets right. However, if you understand the assets well, you can choose and time your trades better than others. You should add your own flavour to the strategy (see the rest of this section) to outsmart your competiton. The general idea here is that you want to enter and exit the trades when the deviations are slightly higher than the recent average. If you look ahead in the graph to spot a profitable exit, and only decide to enter your trade because of that, your trades are biased.

One is that the pairs trade relies on a high statistical correlation between two securities. Most pairs trades will require a correlation of 0.80, which can be challenging to identify. Second, while historical trends can be accurate, past prices are not always indicative of future trends. Requiring only a correlation of 0.80 can also decrease the likelihood of the expected outcome. A pairs trade strategy is based on the historical correlation of two securities. The securities in a pairs trade must have a high positive correlation, which is the primary driver behind the strategy’s profits.

How much does trading cost?

However, companies in the same sector, such as supermarkets, or mining, usually see their correlations remain constant. Another way to do this is to run a “pairs” trading strategy that consists of more than 2 assets per strategy. Another example is that your pairs trade might only work during volatile periods. In this case, you might only want to execute it during the periods that work. Moreover, profits and losses from these idiosyncratic stock effects might cancel out because you have exposure to many stocks.

For most traders, such programs are more of a convenience than a necessity because the slippage that occurs during execution is minimal relative to the profit objective of the overall trade. When a pairs trade performs as expected, the investor profits; the investor is also able to mitigate potential losses that would have occurred in the process. Profits are generated when the underperforming security regains value, and the outperforming security’s price deflates. The pairs trading strategy works not only with stocks but also with currencies, commodities, and options. In the futures market, “mini” contracts—smaller-sized contracts that represent a fraction of the value of the full-size position—enable smaller investors to trade in futures.






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