The Secret to Finding Profit in Pairs Trading

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.

FX pairs with the same ‘base’, eg EUR/USD and GBP/USD, can be highly correlated in a positive direction. 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. Quantitative hedge funds do this and they might have thousands of stocks and make thousands of trades in their high-frequency strategy. However, if you choose to trade 2 stocks, consider doing it over a limited time period (e.g. during the COVID-19 crisis, cruise stocks move together) or use another qualitative layer of analysis. If you use the end-of-day data, you might not be able to enter at the listed prices.

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.

How much does trading cost?

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.

After a few trades, you can have a feel for the average divergences and convergences, i.e. deviations. Leveraged trading in foreign currency or off-exchange products on margin carries significant risk and may not be suitable for all investors. We advise you to carefully consider whether trading is appropriate for you based on your personal circumstances. We recommend that you seek independent advice and ensure you fully understand the risks involved before trading.

The beauty of pairs trading is that it can be utilized by both fundamental investors and technical analysts. The difficulty comes when prices of the two securities begin to drift apart, i.e. the spread begins to trend instead of reverting to the original mean. Dealing with such adverse situations requires strict risk management rules, which have the trader exit an unprofitable trade as soon as the original setup—a bet for reversion to the mean—has been invalidated. This can be achieved, for example, by forecasting the spread and exiting at forecast error bounds. A common way to model, and forecast, the spread for risk management purposes is by using autoregressive moving average models.

The advantage in terms of reaction time allows traders to take advantage of tighter spreads. The strategy monitors performance of two historically correlated securities. Option traders use calls and puts to hedge risks and exploit volatility (or the lack thereof). A call is a commitment by the writer to sell shares of a stock at a given price sometime in the future. A put is a commitment by the writer to buy shares at a given price sometime in the future. As the two underlying positions revert to their mean again, the options become worthless allowing the trader to pocket the proceeds from one or both of the positions.

When these profitable divergences occur it is time to take a long position in the underperformer and a short position in the overachiever. The revenue from the short sale can help cover the cost of the long position, making the pairs trade inexpensive to put on. Position size of the pair should be matched by dollar value rather than by the number of shares; this way a 5% move in one equals a 5% move in the other. As with all investments, there is a risk that the trades could move into the red, so it is important to determine optimized stop-loss points before implementing the pairs trade. If the securities return to their historical correlation, a profit is made from the convergence of the prices. The broad market is full of ups and downs that force out weak players and confound even the smartest prognosticators.

Trading strategy

The strategy is not dependent on market direction, but rather on the correlation between the two markets. The relative performance of the two markets is the key element, and not just whether the market goes up or down, as is the case for those traders that only go long or short. The successful pairs trader will look to make money on the inequality between the two markets and close out the trade when the inequality has been reversed.

Technical investors will just use the price, but since the price is essentially a function of expected earnings in the future, the overall approach is the same. The reason for the deviated stock to come back to original value is itself an assumption. It is assumed that the pair will have similar business performance as in the past during the holding period of the stock. Instead of entering a trade on divergence and betting on convergence, you can enter a trade on divergence and bet that there is even more divergence.

  1. Imagine if we identified and are trading 20 pairs independently.
  2. The algorithm monitors for deviations in price, automatically buying and selling to capitalize on market inefficiencies.
  3. Dealing with such adverse situations requires strict risk management rules, which have the trader exit an unprofitable trade as soon as the original setup—a bet for reversion to the mean—has been invalidated.
  4. Futures are different from stocks in a way that they expire, usually every quarter.
  5. The long/short relationship of two correlated securities acts as a ballast for a portfolio caught in the choppy waters of the overall market.

No representation or warranty is given as to the accuracy or completeness of the above information. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. Correlations can change over time, and strengthen and weaken, as well as changing their correlation from positive to negative.

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.

How does pairs trading work?

Firstly, the matching of a long position with a short one in a correlated instrument creates an immediate hedge, with each part of the trade acting as a hedge against the other. The risk of the trade is therefore controlled to a degree, but is not eliminated entirely. For example, when long and short two companies in the same sector, if both prices fall, then the money made on the short position offsets the loss in the long position.

Forex trading costs

Online trading opened the lid on real-time financial information and gave the novice access to all types of investment strategies. It didn’t take long for the pairs trade to attract individual investors and small-time traders looking to hedge their risk exposure to the movements of the broader market. It is the responsibility of the trader to manage the position according not only to the predetermined buy and sell rules, but also to the changing market environment. The trader must be cognizant of the unexpected news releases affecting either of the instruments in a trade and be prepared to adjust their thinking accordingly. Likewise, they must be mindful of the pair’s price action and constantly adjust the risk/return profile of the trade. In such a situation, the trader could choose 1 of 2 options to prudently manage the trade moving forward.

Pairs Trading – A Real-World Guide

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.

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.

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