Pair Trading: A Beginner’s Guide

Let’s talk about serious things. What to do for those who have no idea where the trend is going? How to make a profit, regardless of the direction of the market? The answers to these […]

Let’s talk about serious things. What to do for those who have no idea where the trend is going? How to make a profit, regardless of the direction of the market? The answers to these questions are provided by market-neutral strategies – the same ones, thanks to which large hedge funds are kept afloat. The simplest of them – pair trading.

How It Works

Pair trading or statistical arbitrage is when two correlating financial assets are traded simultaneously, which move in the same direction for most of the time.

For pair trading, the tools that show stable cointegration on historical data are optimal – despite the divergence of prices, they are trying to reconcile again. The difference in prices between assets (spread) can sometimes increase greatly under the influence of fundamental factors, but in cointegrated pairs it usually returns to the average historical position.

For entries in transactions, periods are used where the correlation between assets is temporarily weakened and the spread is maximized. Within the framework of the pair trading, one financial instrument is necessarily bought, and the second one is sold. Instruments can be stocks, futures, currency pairs – anything.

Pair Trading Strategies

Paired trading is based on two fundamentally different approaches to the calculation of spread: the difference and the ratio. To simplify the perception, let’s mark the tools in the pair as A and B.

  1. Trading in relation – building a spread by dividing the price of the instrument A by the price B. In fact, this is how the Forex charts are plotted: EUR / JPY, GBP / NZD and others. The result is the ratio of the ratio of one asset to another. Trade in relation to the most risky in terms of investment, but quite suitable intraday.
  2. Trade by difference – building a spread by subtraction from the price of the instrument A value B. The result will be the difference in the price of one stock in relation to another. Which approach is more effective? For commodity markets, the standard calculation is always subtraction, trade restrictions and spread spreads. For currencies, as a rule, division is more effective.

How to Calculate The Spread and Select Pairs

The basis of the pair trading is to sell the spread when it is too expensive and buy it when it is undervalued. To determine the fair price level, the tools of technical analysis are used: trend lines, MA, Bollinger bands. The signal to the input will be at the moment when the spread extremes deviate from the set values.

It is believed that for paired trading it is necessary to buy archive quotes and specialized software. But in practice, in most cases, these costs are unnecessary – enough data that is in the terminal. As for paid software, by and large, it only builds spread schedules and considers correlations. With the same success, you can do it yourself in Excel or use a more convenient method – free services of the site megatrader.org. There is also an online tool for automatically pairs matching for pair trading strategies.

How Profitable Pair Trading is ?

The results of trading depend on the level of risk that is embedded in the system, and the quality of the selected spread. For earnings on the spread, the curve of its schedule must be volatile, otherwise the yield potential, net of overheads, will be minimal. What is this cost? First of all, the broker commission for opening a deal. At small timeframes or tick chart, it can lead to a loss of profitable trade. If we are talking about the stock market, the additional expense will be the opening of short positions. It can be leveled by going to futures, but assets must be volatile.

Among the disadvantages of pair trading, one can note the unpredictability of the duration and magnitude of the spread discrepancies, up to the so-called “pair break”. Therefore, the risk limit for the deposit must be established.

Pair trading remains one of the most common market-neutral strategies. The expected potential yield with qualitative selection of pairs and moderate risk here can reach 50-60% per annum. More details about the pair trading can be found here.