Depending on whether the market is trending in a bullish or bearish direction, you can choose from different trading strategies like position trading and short selling. However, what if you cannot identify a definite trend in the markets? In that case, you need a strategy that could be profitable no matter how the market moves. Any strategy that meets these criteria is a market-neutral strategy.
While there are many market-neutral trading techniques, pair trading or pairs trading is one of the most commonly used strategies.
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.
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.
