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.
How does pair trading work?
Pair trading is a market-neutral strategy based on the concept of mean reversion, where two closely correlated securities temporarily drift apart in price. Traders aim to exploit this divergence by going long on the security that appears undervalued and simultaneously shorting the one that seems overvalued. The expectation is that the price gap will eventually return to its historical average, at which point both positions are closed for a potential profit. This strategy is commonly applied in Intraday Trading, Margin Trading Facilities (MTF), and Futures and Options, as it offers the dual benefits of risk mitigation and efficient use of capital.
Steps involved in pair trading:
Step |
Description |
Identify a correlated pair |
Select two securities—such as stocks, ETFs, or derivatives—with a strong historical correlation, typically above 0.80. |
Monitor price divergence |
Use statistical tools and technical indicators to track deviations from the normal price relationship between the two securities. |
Initiate positions |
Take a long position on the underperforming asset and a short position on the outperforming one to capitalise on the expected price reversion. |
Establish risk parameters |
Set clear entry and exit points, stop-loss orders, and target profits to effectively manage risk and avoid significant losses. |
Monitor and adjust |
Regularly observe the trade to ensure the price spread begins to close. If the correlation breaks down permanently, exit the trade to limit losses. |
Close the trade |
Once the price relationship returns to its typical range, exit both positions and realise the profit from the convergence. |
Key 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.
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.
