Forex Trading

Pairs Trading Explained

what is pairs trading

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.

Margin trading is extended by National Financial Services, Member NYSE, SIPC, a Fidelity Investments company. The successful execution of each of the steps is a critical element in the process of becoming a profitable pairs trader. As is the case with any trading methodology, the complexity and success of the final 3 steps, the actual trading, are integrally dependent on the care and skill that go into the first 3. Pairs trading is non-directional and seeks 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.

what is pairs trading

No representation or warranty is given as to the accuracy or completeness of the above information. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. Correlations can change over time, and strengthen and weaken, as well as changing their correlation from positive to negative.

Certain assets diverge during certain hours and converge during other hours. The unpredictability of a single stock will not have an overly large effect on your portfolio. This means that before you enter your hypothetical trade, don’t look at any potential exits. We need to get more accurate data and run backtests using those data.

Drift and risk management

Pairs work is based on a correlation between 2 (or more) stocks, sectors, indexes, or other financial instruments. Think of a highway and the service road that often runs parallel to it. Generally, the service road follows the highway closely but terrain or development will sometimes cause the 2 to diverge. The area between the highway and the service road can be thought of as the spread—the measured distance between the 2 objects traveling together. The pairs trader attempts to measure the spread with statistics in an effort to find a tradable relationship of inequality opportunities. This investment strategy will entail buying the undervalued security while short-selling the overvalued security, all while maintaining market neutrality.

Technical investors will just use the price, but since the price is essentially a function of expected earnings in the future, the overall approach is the same. The reason for the deviated stock to come back to original value is itself an assumption. It is assumed that the pair will have similar business performance as in the past during the holding period of the stock. Instead of entering a trade on divergence and betting on convergence, you can enter a trade on divergence and bet that there is even more divergence.

  1. This material does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument.
  2. Usually, we check for data cleanliness at the backtesting with code stage.
  3. In order to short sell at Fidelity, you must have a margin account.
  4. Quantitative hedge funds do this and they might have thousands of stocks and make thousands of trades in their high-frequency strategy.

The beauty of pairs trading is that it can be utilized by both fundamental investors and technical analysts. The difficulty comes when prices of the two securities begin to drift apart, i.e. the spread begins to trend instead of reverting to the original mean. Dealing with such adverse situations requires strict risk management rules, which have the trader exit an unprofitable trade as soon as the original setup—a bet for reversion to the mean—has been invalidated. This can be achieved, for example, by forecasting the spread and exiting at forecast error bounds. A common way to model, and forecast, the spread for risk management purposes is by using autoregressive moving average models.

After a few trades, you can have a feel for the average divergences and convergences, i.e. deviations. Leveraged trading in foreign currency or off-exchange products on margin carries significant risk and may not be suitable for all investors. We advise you to carefully consider whether trading is appropriate for you based on your personal circumstances. We recommend that you seek independent advice and ensure you fully understand the risks involved before trading.

Does Pairs Trading Work?

As with all strategies, the most important element is risk management. No investor or trader knows how a trade will turn out, and must always guard against the possibility of losses. By following the risk management rule mentioned above, investors and traders can help limit the downside of any unsuccessful pairs trade.

what is pairs trading

While this would seem to be the most straightforward step in the investment process, there are a few subtleties. Generally speaking, the short side of a trade should be executed and filled before the long order is placed. In addition to the option of manually entering trades, there are some trading programs designed to handle pairs execution. These programs are designed to simultaneously work each side for the trader, particularly for larger orders, in an attempt to hit a pre-specified price ratio.

Pairs trading summed up

Pairs trading strategy demands good position sizing, market timing, and decision making skill. Although the strategy does not have much downside risk, there is a scarcity of opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity. Pairs traders use some type of analysis methodology to confirm the trade and help customize the buy and sell rules. An overlay analysis will help adjust profit objectives and stop loss levels according to the specifics of a given trade. There are many different types of technical and fundamental overlays that can be employed, from candlestick charting to relative strength.

Algorithmic pairs trading

“Quants” is Wall Street’s name for market researchers who use quantitative analysis to develop profitable trading strategies. In short, a quant combs through price ratios and mathematical relationships between companies or trading vehicles in order to divine profitable trading opportunities. During the 1980s, a group of quants working for Morgan Stanley struck gold with a strategy called the pairs trade. Institutional investors and proprietary trading desks at major investment banks have been using the technique ever since, and many have made a tidy profit with the strategy. In the chart below, the potential for profit can be identified when the price ratio hits its first or second deviation.

The advantage in terms of reaction time allows traders to take advantage of tighter spreads. The strategy monitors performance of two historically correlated securities. 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.

Online trading opened the lid on real-time financial information and gave the novice access to all types of investment strategies. It didn’t take long for the pairs trade to attract individual investors and small-time traders looking to hedge their risk exposure to the movements of the broader market. It is the responsibility of the trader to manage the position according not only to the predetermined buy and sell rules, but also to the changing market environment. The trader must be cognizant of the unexpected news releases affecting either of the instruments in a trade and be prepared to adjust their thinking accordingly. Likewise, they must be mindful of the pair’s price action and constantly adjust the risk/return profile of the trade. In such a situation, the trader could choose 1 of 2 options to prudently manage the trade moving forward.