Pairs trading is a non-directional investment strategy that involves two similar markets but with different trading strategies applied. Pair trading entails these opportunities and risks.
• Similar characteristics in markets
• Trading strategies differ
• High correlation essential
Pairs trading: trading similar markets
Pairs trading, also known as pairs trading, is a non-directional investment strategy that involves investing in two markets that share high similarities or similar characteristics. This can be two – or more – stocks, indices, funds, currencies, commodities or a combination of these. The sticking point, however, is that you use different strategies for the two investment goals. An example of pairs trading is picking two similar publicly traded companies and then betting on one going up and the other going down. “In short, pairs trading is betting that the prices of two or more securities will diverge or converge,” financial services firm Fidelity summarizes the strategy.
“Capital from Inequality”
The basic idea here: Investors compare the two markets with one another and enter the “undervalued” market, but sell in the “overvalued” market, according to analyst Chris Beauchamp from the financial services institute IG. This is intended to create a balance between the two markets, which also reduces the trading risk. “The successful pairs trader seeks to capitalize on the disparity between the two markets,” Beauchamp continued. “When the inequality reverses, he closes the trade.” Fidelity emphasizes that tools such as statistics, fundamental data and analysis must be used in order to successfully use the strategy.
This is how pairs trading works
The financial service provider also provides an overview of how such pair trading can actually take place. As a first step, traders should formulate the criteria that the two markets should have. Once these have been defined, a list of possible pair trades that meet the previously defined criteria should then be drawn up. Finally, as a third step, Fidelity names the analysis of the determined markets with the aids already mentioned. The trade is then executed, then managed, and finally, on a strong breakout, closed again. The success of the last three steps – i.e. the trade itself – clearly depends on careful research and, to a certain extent, on the competence of the retailer.
Plus risk reduction
Beauchamp cites the immediate and mutual hedging that arises when comparing a long position with a short position as a major advantage of the strategy. This reduces the risk of trading, although not completely eliminate it. This means that this instrument can prove its worth especially when prices are particularly high, low or stable, but less so when there are small gains or losses. The price development of the two markets comes second, the focus is on the correlation between the two. Investors can reap profits when the previously underperforming market gains and the previously underperforming market falls, explains Investopedia’s James Chen. The sum of profits from both markets is reported as net profit.
Price gains not guaranteed
Nevertheless, losses cannot be ruled out, as Beauchamp emphasizes. However, the overall loss can be significantly mitigated by the profits from the other position. Chen also warns that despite extensive research, the market is often unpredictable. Historical prices can give an indication of possible future price developments, but whether the calculations and expectations actually occur is another matter.
Additionally, successful pairs trades typically require a correlation of at least 0.80, the investment adviser says, with lower interactions reducing the likelihood of expected price action.
Similar position size
According to the stock broker WH SelfInvest, investors who want to do pairs trading should also make sure that both positions are as equal as possible. If both markets are measured in different currencies, the exchange rate of these must also be taken into account. If the positions are held over a longer period of time, deviations in the currency ratio could also affect profits.
So pairs trading has some pitfalls. Although Fidelity points out that the trading strategy can in principle be used by any investor, it is mainly used by professional traders. “Trading pairs can be profitable, but it requires extensive research, close monitoring, clear rules and discipline,” the financial services provider said.
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