Updated July 15, 2023
Definition of Pairs Trading
Pair trading is a kind of trading strategy for hedging risk which involves matching the short position with the long position in two underlying securities having a high positive correlation as the offsetting of the long and short position is the basis for hedging that will provide profits irrespective of the conditions of the market.
Explanation
The basis of Pairs trading is the high correlation between the two underlying securities. The strategy observes the performance of the two correlated stocks, i.e., the trader identifies the two companies of similar nature and characteristics whose equity shares are presently trading at a price relationship that is out of their usual trading range. The strategy involves buying the undervalued share and selling the overvalued share. Pair trading was used for long term trading, but now pair trading can use for a short duration, i.e., intraday trading.
How Does Pairs Trading Work?
Pairs trading involves monitoring the historically correlated securities, and it works on the assumption that the market is neutral, i.e., it assumes that the two securities that have moved historically in the same direction will keep moving in the same direction. Therefore, pairs trading involves choosing two securities that belong to the company having the same industry or are direct competitors. The assumption that the market is neutral expects that the stock that is outperforming will return to the neutral price, i.e., the price will decrease, whereas the underperforming stock will return to the neutral price.
So in Pair trading, when the correlation between the two securities identified as highly correlated by the traders weakens, i.e., the price of one security moves up while the other security moves down. The pairs trade involves selling of outperforming security and buying an underperforming one, thereby betting that the spread between the two given securities would eventually converge by either the price of the underperforming security or a decrease in the price of outperforming security. In all the scenarios discussed, the strategy will make profits, but if both the securities move up or down at the same time and the spread remains the same, then there will be no profit or loss to the trader.
Example of Paris Trading
The profits that can be made using the Paris trade strategy can illustrate with the help of the following example considering stocks 1 and 2.
Suppose the correlation between stock 1 and stock 2 is 0.96, which is very high. So, there can be a Paris trade using these two stocks. Now, it is seen that in the short term, the mentioned two stocks deviated from their past trending correlation, where the correlation is found to be 0.55.
In this case, Stock 1 is the outperforming stock, and Stock 2 is the underperforming stock. So, the arbitrage trader decided to go for the par is trade strategy where it makes a matched amount of long position in stock 2, which is underperforming stock, and a short position in stock 1, which is outperforming stock. Now, over time, stocks converge and then return to their normal correlation of 0.96. With this strategy, traders can close the short position and make profits in the long.
Advantages of Pairs Trading
The advantages of pairs trading are as under:
- Able to Mitigate Potential Losses and Risks: When the pairs trading strategy performs as per the traders’ expectations, then the investor can generate profits, and also, the potential losses are mitigated that occur during the process. It also helps mitigate risks as the pairs strategy involves dealing in two securities, so if one is underperforming, then there are chances that the other absorbs the losses due to the underperformance of one security.
- Profit Earning: It helps the trader earn profits regardless of the market conditions, i.e., pair trading strategy helps the traders make profits no matter if the market is increasing or declining or swinging, etc.
- Hedging: The best advantage of Pairs trading is that the trader is completely hedged, which not an advantage in normal is trading. Hedging is done in this strategy as the trader sells the overvalued security and purchases the undervalued security, limiting the chances of loss.
Disadvantages
The disadvantages of pairs trading are:
- Reliance of The High Statistical Correlation: Pairs trading rely on securities with a high statistical correlation. Most traders require a correlation of at least 0.80, which is challenging to recognize.
- High Commission: Some traders highly discourage Pairs trading because of its higher commission charges. Sometimes even a single Pairs trade requires a Pair trader to pay a commission that is just double the normal commission required in the standard trade.
- Price Filling: The generation of profits in pairs trading involves relying on the margins that are too less, and the transactions are made in large quantities, which shows that the risk of falling stock orders at the desired price when positions are open in a pair trading is high. Even a small difference in the security’s purchase price or sale price can prove significant as the volume of transactions is high.
Conclusion
Thus, Pair trading is a powerful trading strategy based on the assumption that the highly correlated securities or other financial instruments will return to their neutral position after any divergence. This strategy can incorporate into intraday trading or long term trading. Although pair trading can provide profits in any market condition, the correlation must be evaluated carefully, as any wrong assumption or prediction may fail the pair trading strategy.
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