Pair Trading Strategy: A Comprehensive Guide

Pair trading strategy hero

Pair trading presents a fascinating and somewhat distinct tactic in the finance and investment arena. At first, it might come across as complicated, but with some dedication and learning, the pair strategy can serve as the best tool for traders aiming to mitigate risks and capitalize on opportunities across fluctuating market climates. Let's explore the concept of pair trading, weigh its pros and cons, and discuss how you can leverage pair strategy to bolster your trading portfolio.  

What is Pair Trading

Pair trading is one of the best methods where you invest by purchasing (Long position strategy) and, at the same time, sell or take a short position on another related one (short position trading Strategy).

Pair trading strategy

Pair strategy helps investors best reduce their market risk through hedging. Trading pairs is based on the relationship between two assets, capitalizing on the moments when their prices move apart or come back together. When prices diverge, you can best exploit this gap, and when they converge, there's an opportunity to profit by closing both positions. 

Key Takeaways

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Pair trading is a strategy that involves trading two linked assets, aiming to benefit from their relative movements by going long on one and short on another. 

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The success of pair trading hinges on the correct identification of the correlation between two assets. 

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By speculating on the performance difference between the matched CFDs rather than market trends, the pair strategy helps lower exposure to broader market volatility. 

This versatile technique goes beyond just stocks and can be applied to futures, options, currency pairs, and indices, as well as within your shares trading strategy, position trading strategy, and crypto trading strategy. Its roots can be traced back to the statistical arbitrage strategies developed by number-crunching analysts in the 1980s on Wall Street. Since then, it's been effectively adapted by traders of all levels, from solo traders to big financial institutions, as one of the best ways to achieve financial gains. 

How Pair Trading Strategy works

Step 1: Choose a Pair of Related Assets

Begin by pinpointing two assets with a strong historical correlation. These could be stocks from the same sector, ETFs mirroring the same index, or companies within a similar marketplace. 

Step 2: Conduct Research and Analysis

Investigate both assets extensively, examining past price behavior, correlation trends, and basic financial data to pinpoint prospective opportunities to go short and long, and determine when to initiate and conclude a position. However, past performance cannot be an indicator of future performance.

Step 3: Calculate the Correlation and Spread

Use statistical software to find the correlation coefficient for the assets, measuring how their prices move together. Also, calculate the price gap between them, guiding your decisions on when to enter or leave a position. 

Step 4: Set Up a Watchlist and Monitoring System

Set up a watchlist for your selected assets. Through the easyMarkets trading platform or your easyMarkets TradingView, MT4, or MT5 account, track these assets and establish alerts for major price shifts or correlation changes. 

The information found on easyMarkets platform is intended only to be informative, is not advice nor a recommendation, nor research, or a record of our trading prices, or an offer of, or solicitation for a transaction in any financial instrument and thus should not be treated as such.

Step 5: Define the Entry and Exit Criteria

Decide on specific conditions for starting and finishing such a trade, including correlation levels and spread ratios. Set your potential profit goals and loss limits to reduce risks and safeguard investments. 

Step 6: Execute the Trade

When your entry conditions are met, execute your trade by buying or taking a long position on the undervalued asset and selling or taking a short position on the overpriced one.  

Step 7: Evaluate the Results

Finally, review how effective your trade has been. Analyze your potential profits, weigh them against expected outcomes, and look for opportunities to improve your strategy for more success in the future. 

Pair Trading setup on TradingView

Pair trading stands out as a distinct tactic often favored by seasoned traders to benefit by the market movements. If you're gearing up to embark on a venture using this tactic with easyMarkets using the TradingView platform, here's a guide to best get your trading system up and running: 

Step 1: Account Creation

Begin your TradingView experience by signing up for an account. The platform offers a range of subscription plans, each with its own set of features such as advanced charting tools and access to real-time market data, tailored to the package you select. 

Pair trading strategy

Step 2: Pair Selection

After setting up your account, the next move is to pick your set of securities. Find two financial instruments that closely track each other—this might include stocks, indices, forex, commodities, or others—guided by your research and the tactics principles.  Head to the main dashboard and enter the name of your first CFD into the search bar, then press enter. A chart for the selected CFD will appear in a new tab.

Pair trading strategy

Step 3: Chart Setup

Repeat this process to create a second CFD chart, allowing you to compare it with the first and conduct correlation analysis. To split your chart, you can simply click the grid-like chart layout icon at the top right and select your desired layout from the dropdown menu to effortlessly arrange multiple charts on your screen.

Pair trading strategy

Step 4: Identifying Divergence and Convergence

The secret to effective pair trading lies in spotting moments when your selected CFDs drift apart and when they move back together. It's crucial to keep a close watch on your set of securities charts to pinpoint significant separations—this is when you'll want to initiate a position—and recognize when they're realigning, which signals the time to close your positions. 

Pair trading strategy

Step 5: Setting Alerts

You can streamline your monitoring tasks by setting up alerts on TradingView. Just click on the 'Alert' icon situated on the upper left side of the main trading interface. This will bring up a window where you can specify trigger conditions for your alerts, such as changes in the CFD's price or a moving average crossover. Then, you get to choose how you'd like to be notified—whether through email or a push notification on your mobile app. With this setup, you'll be promptly informed about significant market movements that require your attention.  

Pair trading strategy

You're now equipped for pair trading on TradingView. Keep in mind that although TradingView is one of the best resources for market analysis and executing a long or short position, all trading carries inherent risks. Do your due diligence with thorough research and approach your trading with caution and responsibility. 

Disclaimer:

easyMarkets Account on TradingView allows you to combine easyMarkets industry leading conditions, regulated trading and tight fixed spreads with TradingView's powerful social network for traders, advanced charting and analytics. Access no slippage on limit orders, tight fixed spreads, negative balance protection, no hidden fees or commission, and seamless integration. Any opinions, news, research, analyses, prices, other information, or links to third-party sites contained on this website are provided on an "as-is" basis, are intended only to be informative, is not an advice nor a recommendation, nor research, or a record of our trading prices, or an offer of, or solicitation for a transaction in any financial instrument and thus should not be treated as such. The information provided does not involve any specific investment objectives, financial situation and needs of any specific person who may receive it. Please be aware, that past performance is not a reliable indicator of future performance and/or results. Past Performance or Forward-looking scenarios based upon the reasonable beliefs of the third-party provider are not a guarantee of future performance. Actual results may differ materially from those anticipated in forward-looking or past performance statements. easyMarkets makes no representation or warranty and assumes no liability as to the accuracy or completeness of the information provided, nor any loss arising from any investment based on a recommendation, forecast or any information supplied by any third-party.

Real example of a Pair Trading Strategy

For a clear illustration of the pair tactic consider a made-up scenario with two indices, "Index A" and "Index B," which have typically moved together.  

On January 1, Index A stands at 1200 points, Index B at 2200 points, usually giving a price ratio of around 0.55 (1200/2200). Days later, both indices drop due to market fluctuations, with Index A at 850 points and Index B at 1980 points, now at a 0.56 ratio, signaling a move away from their usual correlation.  

According to the rules of pair trading, it's likely they'll return to their average ratio. Spotting this, a savvy trader might buy or take a long position on Index A and short or sell Index B, with $1,000,000 allocated to each.  

After a few weeks, both indices begin to recover, with Index A back at 1200 points and Index B at 2180 points. The ratio stabilizes closer to historical norms, around 0.55. The trader then unwinds both positions, with Index A now worth roughly $1,411,764 ($1,000,000 * (1200/850) ), translating to a profit, and the short on Index B resulting in a slight loss, valued around $908,256 ($1,000,000 * (1980/2180) ).

Despite the loss of $91,743 from Index B, the gains of $500,000 from Index A still secure an overall net profit. With the combined transactions, a profit of $408,257 is the result, deeming the strategy successful in generating a net gain. 

It’s important to note that Pair Trading strategies do not always work out as intended. Take, for example, the following strategy:

A seasoned Trader noticed that Company A and Company B’s stocks historically followed a 0.5 price ratio. On a particular day, Company A traded at $100 per share, and Company B at $200, maintaining their price correlation. The Trader decided to execute a pair trade when Company B announced a technological breakthrough, bumping its price to $130, while Company B’s unexpected legal troubles sank its price to $180. The divergence in their ratio became 13:18, quite off from the usual 0.5.

The Trader, trusting in Pair Trading’s reversion to mean principle, expected the stocks to realign with their historical ratio. He invested $10,000 in Company A and shorted an equal amount in Company B. When the market closed, the Trader owned 76.92 shares of Company A ($10,000 / $130), and owed approximately 55.56 shares in Company B ($10,000 / $180).

Weeks passed, but the expected reversion didn't materialize. Company A faced regulatory issues dropping its shares to $85, valuing the Trader’s position at $6,538.46. Company B resolved its legal issues, and its stock rebounded to $220, so the Trader’s short position was now worth $12,222.22. When the Trader liquidated the positions, his Company A shares sold for a $3,461.54 loss, and covering the Company B short cost him an additional $2,222.22, leading to a total net loss of $5,683.76. The market hadn't behaved predictably, and the divergence between the stock prices widened instead of narrowing, contrary to what the pair trading strategy presupposed.

Is the Pair Trading Strategy for You?

Deciding the pair strategy fits your investment style boils down to your comfort with risk, your trading goals, and your experience with trading. Although it is one of the best favored strategies in trading as you can simultaneously buy (take a long position) and sell or take a short position on two correlated assets, aiming to potentially benefit from how they perform against each other. The pair strategy demands a solid grasp of market dynamics, the knack for technical analysis, and the skill to anticipate the assets’ interplay. 

Yet, it's important to be aware that pair trading has its share of hazards, including market swings and the potential for unexpected shifts in the relationship of assets. If you’re well-versed in going long or short when pair trading, understand its intricacies, and are ready to manage these risks, then this could be an intriguing strategy for you to consider. Now, let's take a closer look at the advantages and disadvantages of engaging in the pair trading technique. 

Pair Trading Strategy Advantages

The pair strategy comes with several enticing benefits that stand out from conventional trading techniques: 

1. Market Neutrality: One of the most attractive features of pair trading is its indifference to the market's direction. Your potential benefit depends onvf the relative movement of the paired assets, not on bullish or bearish market trends. This characteristic allows for making potential gains even when the market is declining. 

2. Risk Management: Since pair trading inherently involves hedging one investment against another, it has the potential to substantially minimize investment risks. 

3. Applicability Across Markets: Pair trading isn't confined to just one kind of asset or marketplace, showcasing its adaptability in various trading environments. 

Pair Trading Strategy Disadvantages

However, along with its benefits, the strategy carries certain drawbacks: 

1. Correlation Dependence: The effectiveness of pair trading hinges on the continuous correlation between the selected assets. A weakening or disruption of this correlation could undermine the strategy's success. 

2. Complexity for Novices: Unlike simple buy-and-hold strategies, pair trading involves a more intricate understanding of concepts like correlation, and the dynamics of divergence and convergence. Newcomers to pair trading might find this complexity daunting. 

3. Research-Intensive: Identifying ideal pairs of securities for trading demands in-depth research, which can be extensive and time-intensive, potentially placing a heavy demand on investors' resources. 

Despite these challenges, the rewards of pair trading are often significant for those who are well-prepared and experienced in the trading space. 

Conclusion

Grasping pair trading hinges on understanding how assets relate to each other, spotting market irregularities, and managing positions with a clear sense of risk. It opens up innovative avenues for investment handling and portfolio diversification. But remember, every trading style comes with its risks. Entering the pair trading arena requires doing your homework and carefully evaluating potential risks to ensure you maximize its benefits while skillfully navigating its challenges. 

Pairs Trading Strategy is particularly compelling in CFD trading as it exploits the hedging potential intrinsic to CFDs, offering a buffered investment approach even in turbulent markets. Unlike traditional stock trading, CFDs enable traders to execute the pair strategy without the requirement of large capital, as traders can go long or short with greater financial leverage. The pair strategy in CFD trading is uniquely beneficial for its market-neutral stance, striving to benefit from the relative performance of two assets rather than from the direction of the broader market. 

Pair trading offers a refreshing alternative, providing exciting opportunities to benefit from meticulously matched pairs of CFDs. So go ahead – dive into the details, get to grasp the subtleties, and enjoy the rewards that this distinctive trading technique offers. However, it's crucial to acknowledge the risks. A trader can expect two historically correlated stocks to revert to their usual price ratio after a divergence but can end up with a significant loss when one's value drops while the other's price climbs. Caution is always advised.

Pair trading presents a fascinating and somewhat distinct tactic in the finance and investment arena. At first, it might come across as complicated, but with some dedication and learning, the pair strategy can serve as the best tool for traders aiming to mitigate risks and capitalize on opportunities across fluctuating market climates. Let's explore the concept of pair trading, weigh its pros and cons, and discuss how you can leverage pair strategy to bolster your trading portfolio.  

Frequently Asked Questions

To identify the best suitable candidates, you can start by selecting assets from the same or similar sectors, with similar market capitalization, and correlated performance. Additionally, comparing historical price data, examining fundamental factors, and using statistical techniques like cointegration analysis can also aid.  

Some common tools and software include statistical analysis software (such as R or MatLab), charting and technical analysis software (e.g., TradingView), and trading platforms that support the best Pairs Trading Strategies (e.g., the easyMarkets trading platform). 

The pair strategy can be effective in sectors or markets where there is a high correlation between two stocks or assets. Sectors such as technology, finance, and consumer goods often have stocks with a strong correlation, making them ideal for pair Trading Strategies. 

  1. Ignoring correlation: Failing to consider the correlation between two assets can result in poor decisions. 
  2. Lack of diversification: Depending too heavily on one set of securities or not diversifying across multiple pairs can increase risk.
  3. Overlooking transaction costs: Failing to account for transaction costs can erode potential profits. 
  4. Not monitoring the set of securities: Neglecting to consistently monitor the pair's relationship and adjusting positions accordingly can lead to missed opportunities or losses. 
  5. Overfitting the model: Over-optimizing the trading strategy to historical data can result in poor performance in live trading. 

The duration of going long in pair trading can vary depending on the strategy and the specific market conditions. Some traders may hold such a trade for a few days, while others may hold it for several weeks or even months. 

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