Pair trading is a market-neutral trading strategy that involves the simultaneous buying and selling of similar (correlated) assets.
This method can be applied equally successfully on the currency and stock markets, as well as on the commodities market. The most difficult part of this type of trading is the selection of assets.
In this article we will tell you about the basic principles of the paired trading, the basic ways to choose the instruments for it, and give examples of its use in the real market.
What is the pair trading?
Pairs Trading is a trading strategy based on simultaneous trading of two financial instruments that are correlated with each other in different directions.
Correlation is a statistical relationship between two or more values (assets). It may be direct or reverse. In the first case, the price movement of one asset practically repeats all movements of the price of the other asset. In the case of inverse correlation, the charts of trade instruments look mirror-like.
An example of the direct correlation is the behavior of prices of oil and shares of oil companies. When oil prices go up, stocks go up as well. When there is an inverse situation – a drop in prices – the values of these assets will also correlate with each other, but in the direction of the drop.
However, each oil company stock will rise or fall in its own way, some more than others. This temporary divergence in the prices of correlated stocks can be used for pair trading.
The paired trading strategy uses the equilibrium principle according to which periodic divergences of steadily correlated instruments tend to return to their usual average values. Such divergences are most often caused by significant fundamental events (changes in the Central Bank rates, corporate events, etc.).
The essence of the strategy is to identify a pair of financial instruments with a high degree of correlation, one of which has significantly increased or decreased in price relative to the other. After that the overpriced asset is sold and the undervalued one is bought at the same time.
This creates a market-neutral portfolio of two oppositely directed positions whose profitability will depend not on the general direction of the market, but on the price difference between the two instruments. It is expected that after some time the correlation will be restored and the price ratio will return to its previous values, after which both positions can be closed.
How to Choose Instruments for Pair Trading?
The choice of assets for this strategy involves the use of fundamental and technical analysis, as well as statistical calculations. In general, you can start looking for tools for pair trading among:
- Stocks of companies belonging to the same market sector.
- Contracts for similar commodities: Brent and WTI oil, gold and silver, etc.
- Currencies that have a certain correlation.
A popular way to assess the correlation of the two instruments is to calculate the Pearson correlation. The stronger the correlation of assets, the more likely they are to move in the same direction. Also used is such a concept as cointegration – a statistical property of two or more variables that shows the stability of their relationship.
Examples of using pair trading
Let’s look at several examples of using pair trading in different markets.
Stock Market
Pair trading can be used for trading stock indices and shares of companies operating in one or related sectors. From time to time events occur that can lead to violations of the correlation of the prices of such assets, such as the conclusion of large contracts or the development of new products. The general mood of the stock market also has a significant impact on the quotations.
Commodity market
For paired trading you can take contracts on similar commodities, such as oil and natural gas, gold and silver. It is also possible to use different types of contracts for the same commodity.
Forex currency market
In Forex, for pair trading, you need to choose two similar currency pairs. For example, EUR/USD and GBP/USD have a positive correlation. But this correlation is unstable, which is why pair’s charts can diverge by a very large distance and not converge back for a long time. In fact, trading EUR/USD and GBP/USD spread is similar to trading their cross – EUR/GBP. When there is a steady trend in EUR/GBP, the EUR/USD and GBP/USD correlation is broken.
Risk Management in Pair Trading
Like any other trading strategy, paired trading requires risk management. Although the position is market-neutral, an unexpected news release affecting one of the traded pair’s assets can drastically change the speed and direction of spread movements. Therefore, it is necessary to formulate criteria for limiting losses in advance.
Since the strategy depends on the change of the spread value, setting Stop Losses for each instrument of the pair will be irrelevant. As an alternative, it is possible to be guided by the total loss on both positions. It is necessary to determine an acceptable amount of risk for the transaction (for example, 3% of capital), and if the total loss on positions reaches this value, close them.
Conclusion
Pair trading is a popular market-neutral trading strategy. It may seem simple only at first glance. To be successful, a trader needs to know how to find appropriate tools, correctly use statistics and choose the best moment for deals.
Also, it is necessary to observe the rules of risk management. Before risking real money, one should test their skills of pair trading on a demo account.