The Secret to Finding Profit in Pairs Trading

The strategy is not dependent on market direction, but rather on the correlation between the two markets. The relative performance of the two markets is the key element, and not just whether the market goes up or down, as is the case for those traders that only go long or short. Pairs trading is non-directional and seeks Pepperstone Forex Broker to use two markets where prices are currently trading in a relationship that is outside their historical trading range. The idea is to buy the market that is undervalued relative to the other, while selling the one that is overvalued. It seeks to maintain neutrality by keeping the exposure on each trade identical.

  1. Many people consider pairs trade to be a form of financial hedging.
  2. The relative performance of the two markets is the key element, and not just whether the market goes up or down, as is the case for those traders that only go long or short.
  3. However, there are times when this relationship breaks down, and the two assets move in opposite directions.
  4. Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors.
  5. By identifying two correlated securities, traders can exploit deviations from their historical price spread, betting on a reversion to the mean.
  6. However, if you understand the assets well, you can choose and time your trades better than others.

To do stocks pairs trading well, we should have many pairs (maybe hundreds) running at appropriately low position sizes. We use the Bollinger Bands indicator to spot the times when the correlation between the two stocks has moved too far from the norm, which will result in a trading opportunity. In the chart below we can see that General Motors and Tesla often move in tandem. 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. Overall, the two trades matched should give us a neutral or risk-free position that allows traders to make a profit in the market. The best forex pairs to trade with this market neutral strategy are the ones with the highest correlation.

It can also be referred to as market neutral or statistical arbitrage. Option traders use calls and puts to hedge risks and exploit volatility (or the lack thereof). A call is a commitment by the writer to sell shares of a stock at a given price sometime in the future. A put is a commitment by the writer to buy shares at a given price sometime in the future. As the two underlying positions revert to their mean again, the options become worthless allowing the trader to pocket the proceeds from one or both of the positions.

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In the futures market, “mini” contracts—smaller-sized contracts that represent a fraction of the value of the full-size position—enable smaller investors to trade in futures. Pepsi (PEP) and Coca-Cola (KO) are different companies that create a similar product, soda pop. Historically, the two companies have shared similar dips and velocity trade highs, depending on the soda pop market. One is that the pairs trade relies on a high statistical correlation between two securities. Most pairs trades will require a correlation of 0.80, which can be challenging to identify. Second, while historical trends can be accurate, past prices are not always indicative of future trends.

Pairs trading strategy

In other words, traders participating in this trading approach will look for highly correlated strategies. A pairs trader in a market neutrality concept can expect a price rise of their underperforming assets as well as the price of their overperforming assets to decline soon. This investment strategy will entail buying the undervalued security while short-selling the overvalued security, all while maintaining market neutrality.

In the chart below, the potential for profit can be identified when the price ratio hits its first or second deviation. When these profitable divergences occur it is time to take a long position in the underperformer and a short position in the overachiever. The revenue from the short sale can help cover the cost of the long position, making the pairs trade inexpensive to put on. Position size of the pair should be matched by dollar value rather than by the number of shares; this way a 5% move in one equals a 5% move in the other. As with all investments, there is a risk that the trades could move into the red, so it is important to determine optimized stop-loss points before implementing the pairs trade. The broad market is full of ups and downs that force out weak players and confound even the smartest prognosticators.

You should add your own flavour to the strategy (see the rest of this section) to outsmart your competiton. The general idea here is that you want to enter and exit the trades when the deviations alpari review are slightly higher than the recent average. 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.

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Why Does the Pair Trading Strategy Work?

Firstly, the matching of a long position with a short one in a correlated instrument creates an immediate hedge, with each part of the trade acting as a hedge against the other. The risk of the trade is therefore controlled to a degree, but is not eliminated entirely. For example, when long and short two companies in the same sector, if both prices fall, then the money made on the short position offsets the loss in the long position. Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors.

Using Cointegration for Pair Trading

The successful pairs trader will look to make money on the inequality between the two markets and close out the trade when the inequality has been reversed. As mentioned, if you are running a pair trading strategy on stocks, you probably need to run the strategy on more than a single pair of stocks. If you are running a pair trading strategy on stocks, you probably need to run the strategy on more than a single pair of stocks. In order to short sell at Fidelity, you must have a margin account. Short selling and margin trading entail greater risk, including, but not limited to, risk of unlimited losses and incurrence of margin interest debt, and are not suitable for all investors. Please assess your financial circumstances and risk tolerance before short selling or trading on margin.

What are the risks associated with Pairs Trading Strategy?

FX pairs with the same ‘base’, eg EUR/USD and GBP/USD, can be highly correlated in a positive direction. Meanwhile, Brent and WTI can also be positively correlated in the commodities space, while many commodities tend to move inversely to the price of the US dollar. A trade that sees profits of $1000 on one day, but then the second day sees that fall to $500 has a drawdown of $500. But the loss on one position is tempered by profits on the other, and thus the expected drawdown of the strategy can be smaller.

For instance, a stock might move 1% a day on average, while a cryptocurrency coin moves 5% a day on average. Buying and shorting $1,000 on each will bias the impact of your pairs trade towards the cryptocurrency. You will know when to enter the trade and when not to, even as the 2 assets diverge and everyone else is entering the pairs trade.

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