Pairs Trading Overview, Selection Process, Advantages

what is pairs trading

To do well with stock pair trading, we should have a large number of pairs (perhaps hundreds) running at acceptable position sizes. The volatility of a single stock will have little impact on your overall portfolio. As previously said, if you are using a pair trading technique on stocks, you will most Bottom up investing 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 start a trade, you must do in-depth research of the pairs you’re trading. For example, you can trade Bitcoin vs. Ethereum, Cardano vs. Solana, Ethereum vs. Link, and other coins.

It offers you several courses and helps develop proficiency in it. You’ll need confidence, experience, and a large account with futures trading approval. But the concepts discussed here can be applied to any pairs trade.

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This reversionary price move could be independent to the general market direction. In most cases, if a short position loses a predetermined amount of money, the broker could force you to close the position or add more money to your account to cover your losses. You will make a quick profit if the two stocks return to $100. For example, if your long position in Stock A at $90 returns to $100, you’ll profit $10 for each share you bought. In addition, if your short position in Stock B at $110 also returns to $100, you’ll receive an additional $10 for every share that you shorted.

What Are the Drawbacks of Pairs Trading?

Let’s open two trades, a Down trade on MasterCard and an Up trade on the 2nd asset. The stock of Mastercard started falling and Visa’s Up trade went to zero. While the first one was profitable, it is best to close both trades and observe how the shares continue to move in sync thereafter. When trading on the differential movement of two securities, you either speculate that they will narrow (convergence) or wide (divergence). The reason is that the disparity in value may sometimes widen further – outside historical boundaries – causing losses to the pair trade. Let’s say that you decide to open a long position for gold and short an equivalent amount of silver in a pairs trade.

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. The best pairs for trading are highly liquid pairs such as BTC/USDT, ETH/USDT, and other high-market-cap cryptos.

The positions are based on the current market price of both the stocks and their standard deviation. The idea behind a pairs trade is to take advantage of divergences in highly correlated securities. To increase the odds of success, track relationships over time, identify price divergences, and hypothesize when they may come back in line. Treasuries and U.S. stocks higher, at least in the short term. You think Treasuries have reached a top but that the SPX still has room to move higher. You could consider a pairs trade that’s short Treasury futures and long SPX futures.

Step #1: Identify Two Correlated Stocks that have a strong positive correlation

Moreover, because pairs tend to yield smaller unleveraged returns than buy and hold, traders use leverage to boost earnings. Note that, regardless of the strategy used, pairs trading requires finding two highly correlated assets and trading in a way to benefit from the divergence or convergence of their prices. Pairs trading involves being neutral to the direction of the market.

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Your profits on a pairs trade are based on relative returns, meaning that one position is doing better than the other. For example, you can use stocks as long as the two listings are correlated and have some type of relationship. But a long stock/short stock pairs trade can use up a lot of trading capital and comes with significant risk if the pair should move against you. With an appropriately approved account, certain options spreads like verticals can offer lower capital requirements and defined risk.

How Can You Get Started with Pairs Trading?

It can help you identify trends and patterns in the market that will allow you to make better nifty future trading strategies. The strategy monitors performance of two historically correlated securities. Pairs trading is a popular strategy, but like all strategies it is not without risks and it is not successful all the time. As with all strategies, the most important element is risk management.

what is pairs trading

The only question is how does each security move against one another during the bull and bear phase. If we can find out more about their characteristics, then we can design an appropriate pairs trade strategy. Added factors like news releases or economic data can also create short-term havoc against pairs trade. For example, better-than-expected unemployment data causes the weakest stock (that you are short) to soar while the lower beta one (that you are long) to lag. With the advent of fast trading terminals, traders often use software to initiate, backtest, filter and program pairs trading. The premise is that the undervalued security will appreciate over time – and the overvalued one will fall.

Pairs Trading Strategy – How Does Pairs Trading Work? (What is it?)

To make this strategy accessible to our users, we are proud to introduce a new bot called the Bear Fighter bot. In this article, we delve more into one such strategy called ‘Pairs trading’. The information on this website is prepared without considering your objectives, financial situation or needs. Consequently, you should consider the information in light of your objectives, financial situation and needs.

  • Once the pair of stocks is co-integrated, they can be considered for the pairs trading strategy.
  • If the correlation is high, say 0.8, traders may choose that pair for pairs trading.
  • Google and Microsoft could be included in this stock pair trading strategy as well, but they tend to have higher exposure to other markets.
  • The transactions are made in large quantities which shows the risk of filling the stock orders at the desired price when positions are open in a pair trading is high.
  • The revenue from the short sale can help cover the cost of the long position, making the pairs trade inexpensive to put on.
  • To make this strategy accessible to our users, we are proud to introduce a new bot called the Bear Fighter bot.

Discover the range of markets and learn how they work – with IG Academy’s online course. Testimonials on this website may not be representative of the experience of other customers. No testimonial should be
considered as a guarantee of future performance or success. The Dickey Fuller test is a hypothesis test which gives a p-value as the result. If this value is less than 0.05 or 0.01, we can say with 95% or 99% confidence that the signal is stationary and we can choose this pair.

When the correlation stops, then we’re presented with a trading opportunity to short-sell General Motors when it’s outperforming and go long Tesla when it’s underperforming. What we look for are correlated stocks that have short periods when they diverge from one another. If these stocks have a strong correlation, then eventually they will revert back from trading in tandem. Because stocks are driven by supply and demand, they don’t trade in isolation; they tend to be affected by other stocks and broader market conditions. This means we can’t accurately assess how well or poorly a stock has performed by looking at its price action; we need to compare it with other relevant stocks.

Finding Correlated Stocks

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. This investment strategy will entail buying the undervalued security while short-selling the overvalued security, all while maintaining market neutrality. It can also be referred to as market neutral or statistical arbitrage. This style of pair trading strategy requires careful attention to market movements and some foresight into how traders may react under certain circumstances; for every pair tradable. For example, in shares or futures contracts, a willing buyer and seller must agree upon a reasonable price before taking control of those assets from the other party.

If that happens, your losses could exceed the amount you have in your account. Say Stock A and Stock B are both $100 and have a high correlation. Because the correlation is not perfect, sometimes the two stocks do not move in the same direction. If you notice that Stock A has moved down to $90 and Stock B has moved up to $110, you may have a chance for a pairs trade. It is extremely important that the evaluation of the correlation must be made carefully as any wrong assumption or prediction may result in the failure of the pairs trading strategy. Pairs Trading is a trading strategy that matches a long position in one stock/asset with an offsetting position in another stock/asset that is statistically related.

Any pair that you find have probably been watched like a hawk. Even if you choose 2 decent assets, it is unlikely that you will make money if you blindly trade every divergence. 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. A safer approach is to wait for the ratio to start moving back towards normal. Additionally, you can also use the recent swing highs and lows that will develop as a place to hide your protective stop loss. 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.