Pairs trading is a market-neutral trading strategy which allows investors to profit from the past stock performance by placing long and short bets.
Pairs trading was first utilised in the mid-1980s to uncover prospective profits using technical and statistical research. However, it was only available to Wall Street experts before the internet made online trading and real-time financial data available to the general public. Before long, seasoned amateur investors were profiting from pairs trading while limiting their risk exposure.
What is Pairs Trading?
Pairs trading is a day trading method in which an investor takes long and short positions in two stocks that have historically had a high correlation but have recently drifted apart.
The degree to which two securities move in respect to one another is referred to as correlation. In more technical terms, correlation is a statistical measure of the link between the historical performance of two assets. A correlation coefficient is a common way of expressing it.
This indicator ranges from negative to plus one, with minus one suggesting that two securities move in opposite directions. A positive correlation coefficient means that the two securities move up and down at the same time under the same conditions.
Pairs Trading Example
An investor will hunt for two stocks that have previously had a high correlation but have fallen out of sync in a pair’s trade. For example, if stocks A and B have historically risen and fallen in lockstep, their correlation would be extremely strong, possibly as high as 0.95. However, the two stocks have diverged for whatever reason, with A gaining a lot of ground while B has been falling. As a result, the short-term correlation coefficient between the two has been reduced to a pitiful 0.50.
The most usual situation for a pair’s transaction is this. An investor will take a long position on the underperforming stock Alpha. They’ll also short stock Beta, which has outperformed at the same time. In a pairs trade, they’re wagering that the relationship between the two equities will return to its historical norm, whether one security falls, the other rises, or a mix of the two.
Pairs Trading Strategies
Pairs trading is thought to be a “market-neutral” technique. Many of these techniques have the goal of profiting from both growing and decreasing asset prices while avoiding the hazards of the broader market.
Because hedge funds are compensated based on their absolute returns, many will deploy market-neutral techniques. For example, taking a 50 percent long and 50 percent short position in one industry, sector, or market is a common market-neutral trade. They frequently do this to take advantage of price differences in certain places. Aside from making a profit, their primary purpose is often to eliminate as much systematic risk as feasible.
Market-neutral mutual funds are available for less wealthy investors. Because there are so many market-neutral techniques and ways to implement them, the returns on these funds can be quite variable. Before investing, potential investors should familiarise themselves with the fund’s approach to the plan.
Choose non-stock assets
ETFs, futures, non-stock assets, and other derivatives should all be on your radar. In general, I feel it is easier to locate non-stock assets that move similarly to stocks.
Hedge funds are keeping a close eye on these pairs. However, to outsmart your competition, you need to add your flavor to the strategy.
Use multiple pairs if you are choosing assets
As previously said, if you are using a pair trading technique on stocks, you will most likely need to use more than one pair of equities. In today’s market, I believe a single pair of equities is not stable.
To do well with stock pair trading, we should have a large number of pairs (perhaps hundreds) running at acceptable position sizes. This will balance out the differences. The volatility of a single stock will have little impact on your overall portfolio.
Furthermore, because you have exposure to multiple stocks, the profits and losses from these unique stock impacts may cancel out.
Choose a couple of similar assets
As previously said, futures and ETFs make this so much easier. Stocks are a challenge. When trading two equities quantitatively, it is more challenging to pair them. This is due to the difficulty of finding two highly comparable equities.
It’s not good enough to have two stocks from the same industry. If you decide to trade two companies, consider doing it over a short period of time or using another qualitative layer of technical analysis.
Trade the asset that you are comfortable with
Even if you pick two good assets, it’s unlikely that you’ll make money if you trade every divergence blindly. Thousands of hedge funds are scouring the globe for compatible partners. Any pair you come across has most likely been closely scrutinized.
However, if you have a thorough understanding of the assets, you will be able to choose and time your transactions more effectively than others. Even if the two assets diverge and everyone else is trading pairs, you’ll know when to enter and exit the deal.
Steps to Execute a Pairs Trade
There are various measures that investors must take in order to be successful when including pairs trading into their investment strategy.
Decide on Trading Criteria
The first and most time-consuming phase in the process is deciding which securities to evaluate for the trade. This entails looking through a large number of potential investment pairs to locate ones that had a high correlation coefficient in the past but have since drifted apart. Then, using the data, investors will want to construct and test a model for those assets, determining the best potential buy-and-sell criteria as well as how long they want to stay in a trade.
Select Specific Securities
It’s time to put that strategy into action and identify shares that now fulfill that criteria after the investor have decided on a process for selecting candidates for a pairs transaction. Manual research may be used by certain investors, while mathematical models may be preferred by others. In any case, investors must consider how they intend to employ a pair trade.
Investors who wish to get in and out of a trade in a matter of hours or days will need to repeat their process on a regular basis to locate potential transactions. Investors with long-term trades, on the other hand, will not need to do their research as frequently.
Execute the Trade
It’s time to execute a trade once an investor has confirmed that it meets all of their criteria. There are a few minor but crucial aspects to consider while trading pairs. Most experienced pair traders, for example, will execute the short side of the trade before executing the long side.
Manage the Trade
Now that the trade is in place, the investor must sit back and wait. This entails assessing the activity of the two assets in the trade to see if they’re approaching the thresholds that would cause one of the planned buy-and-sell rules to be triggered. It also entails keeping an eye on the broader market, as well as any news that could affect either security in the deal. As markets fluctuate and other news surfaces, experienced traders will constantly modify the trade’s risk/reward profile.
It’s just as crucial to managing the transaction as it is to set it up. So, for example, in case the pair trade that the trader plan to last a month exceeds 50% of their profit target on the first day following execution, the s/he might decide to exit the deal that day since the extra profit isn’t worth the risk or the opportunity cost. They do, however, have other options.
They may use a trailing stop loss level in both positions to lock in a portion of the profit. The decision isn’t simple, and it may entail a variety of other factors.
Close the Trade
The last step is to complete the transaction. But, especially with deals that haven’t worked out and whose planned durations are nearing a close, this might raise problems and challenges. However, this can also be the case with deals that have been successful but are approaching their expiration date.
The desire to give a trade more time to turn around, or to do just a little bit better, has the potential to be a trader’s ruin.
That’s why, when it comes to making regular gains with the technique, experienced pairs traders typically emphasise discipline as being just as vital as study, attentive monitoring, and clear guidelines.
Pros and Cons of Pairs Trading
The approach is market neutral, requiring little attention or time to examine more significant market circumstances. The strategy is also adaptable. For example, short-term traders can generate more trade signals using a lower standard deviation or a shorter time frame.
The likelihood that divergence may stay much longer than predicted or that prices will simply continue to diverge due to fundamental changes in firm structure or performance is also a disadvantage. This is why a risk limit must be set in order to avert a catastrophe if the two equities continue to move out of sync.
Pairs trading goes against standard trend trading principles of purchasing the strongest stocks and selling the weakest, as opposed to traditional trend trading concepts of buying the strongest stocks and selling the weakest. As a result, it might be perplexing and unsettling at times.
Traders must also examine the beta of a stock. There is a difference in volatility between two identical equities with extremely different betas. If one stock is significantly more volatile than the other, the transaction could become problematic. Therefore, pairs should ideally trade highly correlated stocks and have similar betas.
Bottom Line
Pairs trading is a trading method that entails buying and selling stocks at the same time in anticipation of a price movement. The assumption is that the two securities have historically had a strong correlation but have recently drifted apart. The investor who buys a pair bets that the two stocks will return to their historical average.
You can execute pairs trading under the most favorable trading conditions with PrimeFin. What is PrimeFin? It is one of the most well-known forex brokerage firms, which are highly regulated and offer a wide range of asset classes for trading.
Investors interested in gaining hands-on trading experience should consider opening an online brokerage account. ABinvesting is an active investing platform that allows you to choose stocks, ETFs, crypto, and more, as well as manage your account, all from the comfort of your smartphone. Also, aware of the associated risks while pair trading.
