Pairs Trading Definition

This type of strategic trading option is a combination of both long positions and short positions of stocks that are correlated with each other. It is a market-neutral strategy based on not just statistical but technical analysis as well solely to generate potential returns that are market neutralMarket NeutralMarket neutral is an investment strategy or portfolio management technique where an investor seeks to negate some form of market risk or volatility by taking long and short positions in various stocks to increase ROI achieved by gaining from increasing and decreasing prices from one or more than one market.read more. This strategy remains unimpacted by the direction in which the market is moving.

How does Pairs Trading Work?

Pairs trading strategy assumes neutrality in the market; in other words, both the securities will move and will continue to move similarly as they used to. This means that the traders participating in this strategy will search for high correlated securities.

These securities can belong to one industry and sometimes direct competitors too. These highly correlated securities might start diverging in their respective price movements, and it can occur for a few minutes, weeks, or months in the long term.

Pair traders in a market neutrality concept expect the price of the securities that are not performing well at the moment to bounce back. In other words, they expect a rise in the price of their underperforming securities. Pair traders in a market neutrality concept also expect the price of the over-performing securities to fall soon.

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Pairs Trading Example

If ABC stock is correlated to CBA stock, where the former is up 20 points, and the latter is down 20 points, it can be assumed that both stocks will bounce back to their high positive correlation.

Pair Trading Strategy

The historical correlationCorrelationCorrelation is a statistical measure between two variables that is defined as a change in one variable corresponding to a change in the other. It is calculated as (x(i)-mean(x))*(y(i)-mean(y)) / ((x(i)-mean(x))2 * (y(i)-mean(y))2.read more of both stocks is the basis of a pair trading strategy. The key driver of this strategy could be that the stocks participating in the same should necessarily have a higher rate of positive correlationRate Of Positive CorrelationPositive Correlation occurs when two variables display mirror movements, fluctuating in the same direction, and are positively related. In layman’s terms, if one variable increases by 10%, the other variable grows by 10% as well, and vice versa.read more.

Difference Between Pairs Trading and Statistical Arbitrage

Statistical arbitrage can be defined as a modified version of a pairs trading strategy. Statistical arbitrage or StatArb includes such trading strategies that are driven quantitatively. The ultimate objective of each strategy is to yield a higher rate of profits for the trading companies.

Statistical arbitrage is a medium-frequency strategy and not a high-frequency strategy. Statistical arbitrage is mostly applied in financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more, and has become quite popular in hedge funds and investment banks. Unlike pairs trading, statistical arbitrage is not confined to just two stocks or securities. Traders can apply the concept of statistical arbitrage in a variety of correlated stocks. Statistical arbitrage employs large and diverse portfolios traded only for a shorter period.

Advantages

  • Helps in the mitigation of risks– It can help in the mitigation of risks as it deals in the trading of two securities, which means even if one is underperforming, the other can absorb the losses. It helps in the minimization of trading risks arising as a result of movements in the market direction.Guaranteed profits– The trader earns profits irrespective of the market condition. In other words, pair traders will be able to earn returns on trading no matter if the market is swinging sideways, losing, gaining, and so on.

Disadvantages

  • Price Filling: Generating profits in pairs trade relies on too narrow margins, and transactions are required to be done in large volumes, which indicates a high risk that the stock orders will not be filled at an expected price.Commissions: Pairs trading is highly discouraged by a few traders because it demands them to pay a higher commission rate. A single trading pair might sometimes require the trader to pay twice the commission for a standard trade. For traders operating on narrow margins, the difference in commission would be between gains and losses.

Conclusion

In a pair trading concept, whatever the market may move, the correlated securities shall continue to move in the direction they were already moving. In the case of a long trade, underperforming correlated security shall rise in price, whereas, in the case of a short trade, over-performing correlated security shall fall in price.

To conclude, it can be said that pairs trading is one of the most powerful tools of trading as it can help in the mitigation or minimization of risks associated with trading and even enables the traders to earn profits irrespective of how a market is moving. The strategy can even fail if the correlation between securities is not evaluated properly.

This has been a guide to Pairs Trading and its definition. Here we discuss how pairs trading strategy works with an example and compare it with Statistical Arbitrage. You may also have a look at the following articles –

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