What Is a Pairs Trade?
A pairs trade is a trading strategy that involves matching a long position with a short position in two stocks with a high correlation.
Understanding Pairs Trade
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.
Key Takeaways
- A pairs trade is a trading strategy that involves matching a long position with a short position in two stocks with a high correlation.
- Pairs trading was first introduced in the mid-1980s by a group of technical analyst researchers.
- 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.
Market-neutral strategies are a key aspect of a pairs trade transaction. Market-neutral strategies involve long and short positions in two different securities with a positive correlation. The two offsetting positions form the basis for a hedging strategy that seeks to benefit from either a positive or negative trend.
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. 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.
When pairs from the trade eventually deviate—as long as an investor is using a pairs trade strategy—they would seek to take a dollar matched the long position in the underperforming security and sell short the outperforming security. If the securities return to their historical correlation, a profit is made from the convergence of the prices.
Advantages and Disadvantages of Pairs 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 net profit is the total gained from the two positions.
There are several limitations for pairs trading. 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.
Example of Pairs Trade
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 arbitrage trader steps in to take a dollar matched the long position on underperforming Stock A and a short position on outperforming Stock B. The stocks converge and return to their 0.95 correlation over time. The trader profits from a long position and closed short position.
FAQs
Example of Pairs Trade
The arbitrage trader steps in to take a dollar matched the long position on underperforming Stock A and a short position on outperforming Stock B. The stocks converge and return to their 0.95 correlation over time. The trader profits from a long position and closed short position.
How to pair trade work? ›
In a nutshell, pairs trading works by betting that 2 or more securities will diverge or converge in price. The trader bets that a $50 stock and a $55 stock, for instance, will either have a larger or smaller spread ($5 in this case) when the trade is closed.
What is a trading strategy example? ›
Developing a Trading Strategy
Technical traders believe all information about a given security is contained in its price and that it moves in trends. 2 For example, a simple trading strategy may be a moving average crossover whereby a short-term moving average crosses above or below a long-term moving average.
What is the formula for pairs trading? ›
The z-score is simply (spread)/(standard deviation of spread) and spread is calculated based on the stock pair's price history. The basic method to calculate the spread is using a log of prices of stocks A and B. Spread = log(a) - nlog(b), where 'a' and 'b' are prices of stocks A and B respectively.
How many pairs is best to trade? ›
While there are many pairs you could trade for most traders, it is best to stick to one to five pairs and become an expert. There is always a temptation to change markets when making losses. Other forex pairs can appear to have stronger trends, higher volatility, and easier-to-make profits.
What are the disadvantages of pairs trading? ›
Pairs trading isn't without flaws, however. The greatest disadvantage to the strategy is often the fact that when a trader seeks to act on the correlation between the pair to his advantage, the market may not correct within a period of time that is advantageous to the trader.
What is the simplest trading strategy that works? ›
Moving averages are one of the most basic yet effective trading strategies. They calculate the average price of a security over a specified period of time and smooth out price fluctuations, making it easier to spot trends.
Which trading strategy is the best for beginners? ›
Best Intraday Trading Strategies
- Momentum Trading Strategy: ...
- Gap and Go Trading Strategy. ...
- Bull Flag Trading strategy. ...
- Pull back trading strategy. ...
- Breakout Trading Strategy. ...
- Pivot Point strategy. ...
- CFD Strategy. ...
- Scalping Strategy. Scalping is a famous strategy in the Forex market.
“Profit Parabolic” trading strategy based on a Moving Average. The strategy is referred to as a universal one, and it is often recommended as the best Forex strategy for consistent profits. It employs the standard MT4 indicators, EMAs (exponential moving averages), and Parabolic SAR that serves as a confirmation tool.
What is the algorithm for pairs trading? ›
According to The Definitive Guide to Pairs Trading [5], there are 3 main steps to building a pairs trading algorithm: pair selection, spread modeling, and trading rules development. Pair selection aims to find co-moving assets with similar returns and mean-reverting spread.
A potential investor has to find two stocks whose prices have moved together historically, and when the spread between them widens, short the winner and buy the loser. The profits lie in the assumption that history would repeat. If history repeats itself, prices will converge, and the arbitrageur will profit.
How are trading pairs created? ›
Trading Pair definition: Combination of two different cryptocurrencies traded against each other on an exchange, forming trading pairs. The term 'trading pair" refers to a combination of two different types of cryptocurrencies that can be traded against each other.
What is the pairs trading strategy a recommendation system? ›
The Pairs Trading Strategy states that if two stocks exhibit co- movement over a considerable period of time, then this pattern can be exploited for profit. This is done by con- tinuously monitoring the pair for events of divergence from its co-mean.
What is an example of a carry trade strategy? ›
Currency carry trade example: JPY carry trade
To keep it easy you buy 100,000 USD with 9,000,000 JPY at an exchange rate of 90 JPY = 1 USD. As long as the spot rate remains constant, you will gain 5.5% interest on your position after one year. That means your position grows to 105,500 USD. That's a gain of $5,500.
How do I choose a pair to trade? ›
It's important to consider factors like the pair's average daily range, trading times, and costs. By understanding these elements, you can identify pairs that offer the best opportunities for your trading style.
