Pairs Trading Explained
It is assumed that the pair will have similar business performance as in the past during the holding period of the stock. Gordon Scott has been an active investor and technical analyst or 20+ years. In this article, we delve more into one such strategy called ‘Pairs trading’.
- No investor or trader knows how a trade will turn out, and must always guard against the possibility of losses.
- This material does not consider your investment objectives, financial situation or needs and is not intended as recommendations appropriate for you.
- The loss from your long position would be nearly compensated by the gain from your short position if both instruments declined by an amount that was roughly equal.
Correlations can change over time, and strengthen and weaken, as well as changing their correlation from positive to negative. However, companies in the same sector, such as supermarkets, or mining, usually see their correlations remain constant. Even if you choose 2 decent assets, it is unlikely that you will ndax review make money if you blindly trade every divergence. If you use the end-of-day data, you might not be able to enter at the listed prices. In other words, cointegration occurs when two or more non-stationary time series have a stable long-run relationship despite exhibiting some degree of short-term differences.
Sometimes we can get a loss on both trades or other times even see profits on both the long and the short trade. Before utilizing the pair trading strategy we first need to make sure that the instruments we’re going to trade are correlated. What we want to see is a positive correlation where both instruments bdswiss review move in tandem. In this regard, to help minimize the risk of an unexpected event, professional traders can use the pair trading strategy to protect a particular trading idea. Below is a weekly chart of the price ratio between Ford and GM (calculated by dividing Ford’s stock price by GM’s stock price).
Pairs Trade: Definition, How Strategy Works, and Example
With the pair trading strategy, when you lose you only lose small, but the profit potential is so much greater. At the same time, you take an equal-sized short position in another asset. They can be anything from two stocks, currencies, commodities, options or exchange-traded funds (ETFs). This article explores the nuances of what is the pairs trading strategy, providing a robust foundation for both beginners and seasoned traders looking to refine their approach. In addition, with pairs trading you are paying the spread twice, and thus increasing your trading costs.
Another example is that your pairs trade might only work during volatile periods. In this case, you might only want to execute it during the periods that work. However, if you understand the assets well, you can choose and time your trades better than others. However, if you choose to trade 2 stocks, consider doing it over a limited time period (e.g. during the COVID-19 crisis, cruise stocks move together) or use another qualitative layer of analysis. Moreover, profits and losses from these idiosyncratic stock effects might cancel out because you have exposure to many stocks.
What are the benefits of pairs trading?
Let’s assume that we have put at work $10,000 for each of the two stocks. In this case scenario, we would have bought 28 shares of TSLA ($10,000/$350) and sell 270 shares of GM ($10,000/$37). With the first approach, you would have short-sell TSLA on August 2 at $350 a share. The main advantages include its market-neutral stance and the ability to hedge against market volatility, along with the benefit of diversification.
When this happens, it presents an opportunity to profit from the price difference between the two assets. To do this, you need to buy the undervalued asset and sell the overvalued one. Pairs trading is a strategy that speculates on the relative value of two cryptocurrencies rather than their actual price movements. In other words, in a way, the strategy assumes that one cryptocurrency will outperform another in the future. To do this, you need to identify two assets that strongly correlate with each other. This means that when one asset increases in value, the other usually follows suit.
Close the trade
In a nutshell, pairs trading works by betting that 2 or more securities will diverge or converge in price. The trader bets that a $50 stock and a $55 stock, for instance, will either have a larger or smaller spread ($5 in this case) when the trade is closed. Divergence traders will like to see the spread increase while convergence traders will prefer to see the spread decrease. To illustrate the potential profit of the pairs trade strategy, consider Stock A and Stock B, which have a high correlation of 0.95. The two stocks deviate from their historical trending correlation in the short-term, with a correlation of 0.50.
Step #2: Divide the Tesla stock price by GM stock price
The pairs trader attempts to measure the spread with statistics in an effort to find a tradable relationship of inequality opportunities. If the securities return to their historical correlation, a profit is made from the convergence of the prices. Pairs vantage fx broker trading strategies operates under the presumption of market neutrality. This means that if two financial instruments, such as options, futures, currencies, or stocks, have historically exhibited a positive correlation, they will do so going forward.
If the market condition changed and the average deviation is 10%, then a deviation of say 15% is appropriate as your entry and exit points. From 28th Jan to 13th Feb 2019, Z (blue) went up by 6.56% and EWU (red) went up by 3.62%. Then the number on the y-axis is the change in price since the left most point. As a stitched together chart of all the most actively traded contracts. If you find potential in your visual test, you can then move on to testing the strategy using code.