Pair Trading

Pairs trading is an advanced strategy where traders open a long position in one security and a short position in another, aiming to profit from price differences.
Pair Trading
3 mins
26 November 2024

Pair trading is a market-neutral investment strategy that capitalises on price inefficiencies between two correlated securities. By simultaneously buying one asset and selling another, traders aim to profit from the relative price movements, regardless of broader market trends. This approach is particularly useful for mitigating risks and diversifying portfolios, offering traders a balanced exposure to the market. In this article, we will explore the concept of pair trading, its advantages, potential challenges, and effective strategies for successful implementation.

What is pairs trading?

A pairs trade is a trading strategy that involves taking opposite positions in two stocks with a high correlation. The two products could be stocks, derivatives, ETFs, or other securities. These two securities need to have a history of high correlation. And when the prices of these securities deviate, leading to a change in the correlation, you can use that opportunity to profit from the price movement.

Decoding the nuances of pairs trading

Pairs trading relies on the idea of correlation between the prices of two stocks or securities. It measures the extent to which the prices of the two assets move relative to one another. The correlation can range from -1 to +1.

A positive correlation indicates that if the price of one asset increases, the price of the other also goes up (and vice versa). Generally, stocks belonging to the same sector are positively correlated. On the other hand, a negative correlation indicates that if the price of one asset increases, the price of the other decreases (and vice versa). Stocks with negative correlations may belong to opposing sectors like solar energy and oil & gas.

Any value over +/- 0.80 is considered to be a strong correlation. If two stocks that have conventionally displayed a strong correlation deviate from this trend, it is expected that, eventually, their prices will revert to the mean correlation. Pairs trading aims to take advantage of this price movement.

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Attributes of pairs trading

Pairs trading is a strategic approach based on exploiting the relationships between two related securities, allowing investors to profit from price divergences. Here are the key attributes of pairs trading, using a different example from the reference:

  • Securities: Pairs trading involves two distinct securities that are typically related in some way, such as two competing companies. For example, let's consider Stock A and Stock B.

  • Relationship: The foundation of pairs trading is the relationship between the selected securities. In our example, A and B are expected to behave in a similar manner due to their competition in the smartphone market.

  • Relationship deviations: These occur when the historical correlation between the paired securities breaks down, often due to external factors like news or events that affect one stock more than the other.

  • Impact of deviation: Normally, deviations from the correlation are short-lived. In our case, if A experiences a sudden surge in sales, causing its stock to rise while B remains stable, the deviation is expected to correct itself, with the stocks eventually returning to their previous correlation as market forces stabilise. Pairs traders seek to profit from these temporary divergences.

Understanding pairs trading with an example

Let's discuss a hypothetical example to better understand how the pairs trading strategy works. Say two stocks — A and B — belong to the IT sector and have historically been highly correlated, with a correlation coefficient of 0.87.

On account of positive developments within the information technology sector, the price of stock A shoots up. Consequently, the correlation between these two stocks temporarily reduces.

As a trader monitoring these developments, you expect that the price of stock B will also eventually rise to reflect their true correlation. However, you also want to protect yourself from losses if the opposite happens — and the price of stock A falls to revert to the original correlation. So, you take the following positions as a part of your pairs trading strategy:

  • A long position in stock B (since you expect its price to rise)
  • A short position in stock A (as a hedge against unfavourable price movements)

The defining characteristics of pair trading

Now that you’ve seen what pairs trading is and how to identify opportunities for this strategy, let’s summarise the key attributes of this technique.

  • Correlation
    For a pair trade to be successful, correlation is the most essential aspect. You can only execute a pair trade with two securities whose prices are highly correlated.
  • Deviation
    Once correlation has been established, you need a deviation from the historical correlation. This deviation provides the opportunity for a trade.
  • Reason for deviation
    Another key aspect to look into as a part of your pairs trading strategy is the reason for the deviation. This will give you more clarity about the nature of deviation and potential reversion.
  • Leveraging the deviation
    Most deviations from the established correlation are short-lived. So, if you identify an opportunity for a pairs trade, take advantage of it before the prices revert.

The process of selection in pairs trading

The selection process is a pivotal and demanding aspect of the pairs trading strategy. Choosing the right pair is essential for the success of this strategy. Here's an overview of the process of selection:

  • Defining the trading arena: Traders need to decide on their trading arena, which includes considerations such as whether they prefer to trade securities from a particular industry, companies within a specific market cap range, or any other criteria that can help narrow down the choices.

  • Setting criteria: Establishing specific criteria for selecting pairs is vital. These criteria could encompass factors like historical correlation, liquidity, and market fundamentals. These guidelines serve as a filter to identify potential pairs.

  • Time horizon: Determining the intended duration of the trade is crucial. The length of time you plan to keep the trade open will impact the selection process, as some pairs may take longer to revert to their historical correlation.

  • Resource allocation: Assessing the resources available for pairs trading is essential. It's important to have sufficient capital and risk tolerance, as pairs trading may require holding positions for extended periods.

Advantages of pair trading

When done right, pair trading offers many benefits. They include the following:

  • It provides a market-neutral trading opportunity.
  • It minimises your risk due to the opposing positions taken.
  • It can be executed in different market segments.
  • It reduces systematic risk.
  • It is independent of market trends.

Limitations of pair trade

On the flip side, the pairs trading strategy also carries some limitations. They include the following:

  • It requires a lot of research and analysis.
  • It increases exposure to spread risk.
  • It is sensitive to market disruptions.
  • It could be unsuccessful if the stocks selected have low liquidity.

Conclusion

This should give you a clear idea of what pairs trading is and when this strategy can be used. If you are a beginner to trading, practising simulated or demo pair trades is advisable before implementing this trading strategy live. This will help you better manage the nuances of trading in correlated pairs. Additionally, if you are not well-versed in technical and fundamental analysis, you must also improve your skills before attempting the pairs trading strategy.

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Frequently asked questions

How does pair trading work?

Pair trading is a trading strategy that involves simultaneously buying one stock and selling another stock in the same sector or with a high historical correlation. The idea is to profit from the relative price movements of the two stocks. When the price relationship between the two stocks deviates from its historical average, the trader takes positions to benefit from the expected convergence. If one stock in the pair outperforms the other, the trader profits from the long position while offsetting potential losses from the short position, and vice versa.

How do you get stock in pairs trading?

To engage in pair trading, you'll need a trading account with a brokerage that offers pair trading services. After setting up your account, you can follow these steps:

  1. Select a pair: Choose two related stocks that you want to trade together. These stocks should have a historical correlation.
  2. Analyse the pair: Conduct in-depth analysis of both stocks, considering factors like their financials, industry dynamics, and any relevant news or events.
  3. Place orders: Place a long order for one stock and a short order for the other, usually in equal dollar amounts. This creates a market-neutral position.
  4. Monitor and manage: Continuously monitor the pair's performance and adjust your positions if the price relationship starts to deviate significantly from historical averages.
How do you choose pairs for pairs trading?

Selecting pairs for pair trading involves the following steps:

  1. Correlation analysis: Identify pairs of stocks with a strong historical correlation. Stocks in the same industry or sector often work well for this strategy.
  2. Market research: Research the fundamentals of the stocks within the pair, looking at factors like financial health, management quality, and growth prospects.
  3. Liquidity: Ensure that both stocks have sufficient liquidity to easily enter and exit positions.
  4. Divergence assessment: Look for pairs where the historical price relationship has recently deviated, as this may present a trading opportunity.
  5. Risk management: Consider your risk tolerance and capital allocation for each pair.

What are the risks of pair trading?

Pair trading, while considered a lower-risk strategy than some other trading methods, does have its own set of risks. These risks include:

  1. Correlation breakdown: If the correlation between the two stocks in the pair breaks down, the strategy may not work as expected.
  2. Market-wide events: Systemic market events, such as financial crises or sudden market volatility, can impact both legs of the pair trade.
  3. Leverage risks: Some traders use leverage to amplify returns, but this also increases the risk of significant losses.
  4. Execution risks: Timely execution is crucial in pair trading, and any delays can impact the profitability of the trade.
  5. Over-optimization: Over-optimizing the pair selection process can lead to curve-fitting and reduced effectiveness in a live trading environment.
  6. Costs: Trading costs, including commissions and financing costs, can eat into profits.

It's essential for pair traders to manage these risks through thorough research, disciplined execution, and risk management strategies.

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