Definition of Pairs Trading
Pair trading is a kind of trading strategy for hedging of risk which involves matching of the short position with the long position in two underlying securities having a high positive correlation as the offsetting of the long and short position is the basis for hedging that will provide profits irrespective of the conditions of the market.
The basis of Pairs trading is the high correlation between the two underlying securities. The strategy observes the performance of the two correlated stocks i.e. the trader identifies the two companies that are of similar nature and characteristics whose equity shares are presently trading at a price relationship that is out of their usual trading range. The strategy involves buying the undervalued share and selling the overvalued share. Earlier the pair trading was used for long term trading but now pair trading can be used for a short duration i.e. for intraday trading.
How does Pairs Trading Work?
The Pairs trading involves monitoring of the historically correlated securities and it works on the assumption that the market is neutral i.e. it assumes that the two securities that have moved historically in the same direction will keep on moving in the same direction. Therefore, pairs trading involve choosing two securities that belong to the company having the same industry or are direct competitors. The assumption that the market is neutral expects that the stock which is outperforming will come back again to the neutral price i.e. the price will decrease whereas the underperforming stock will be back again to the neutral price.
So in the Pair trading, when the correlation between the two securities that are identified as highly correlated by the traders weakens i.e. the price of one security moves up while the other security move down then the pairs trade involves selling of outperforming security and buying of underperforming one thereby betting that the spread between the two given securities would eventually converge by either the increase in the price of underperforming security or decrease in the price of outperforming security or both. In all the discussed scenarios the strategy will make profits but if both the securities move up or move down at the same time and the spread remains the same then there will be no profit or loss to the trader.
Example of Paris Trading
The profits that can be made using the strategy of the Paris trade can be illustrated with the help of the following example considering stock 1 and stock 2.
Suppose the correlation between stock 1 and stock 2 is 0.96 which is very high. So, there can be Paris trade using these two stocks. Now, it is seen that in the short term the mentioned two stocks deviated from their past trending correlation where correlation is found to be 0.55.
In this case, Stock 1 is the outperforming stock and stock 2 is the underperforming stock. So, the arbitrage trader decided to go for the par is trade strategy where it makes a matched amount of long position in stock 2 which is underperforming stock, and short position in the stock 1 which is outperforming stock. Now, over the period of time, stocks converge and then return back to their normal correlation of 0.96. With this strategy, trader can close the short position and make profits in the long position.
The advantages of pairs trading are as under:
- Able to Mitigate Potential Losses and Risks: When the pairs trading strategy performs as per the traders’ expectations then the investor is able to generate profits and also the potential losses are mitigated that occurs during the process. It also helps in the mitigation of risks as pairs strategy involves dealing in two securities so if one is underperforming then there are chances that the other absorbs the losses which occurs due to the under performance of one security.
- Profit Earning: It helps the trader to earn profits regardless of the conditions of the market i.e. pair trading strategy helps the traders to make profits no matter the market is increasing or declining or swinging etc.
- Hedging: The best advantage of Pairs trading is that the trader is completely hedged which not an advantage in normal is trading. Hedging is done in this strategy as the trader sells the overvalued security and purchases the undervalued security thereby limiting the chances of loss.
The disadvantages of pairs trading are:
- Reliance of The High Statistical Correlation: Pairs trading rely on the securities having a high statistical correlation. Most of the traders require a correlation of at least 0.80 which is very challenging to recognize.
- High Commission: Some of the traders highly discourage the Pairs trading because of its higher commission charges. Sometimes even a single Pairs trade requires a Pair trader to pay a commission which is just double of the normal commission required in the standard trade.
- Price Filling: The generation of profits in pairs trading involves relying on the margins that are too less and the transactions are made at large quantities which shows that the risk of filling of stock orders at the desired price when positions are open in a pair trading is high. Even a small difference in the purchase price or sale price of the security can prove significant as the volume of transactions is high.
Thus, Pair trading is a powerful strategy of trading that is based on the assumption that the high correlated securities or other financial instruments will come back to their neutral position after any divergence. This strategy can be incorporated at the in traday trading or the long term trading. Although pair trading can provide profits in any market condition, the evaluation of the correlation must be made carefully as any wrong assumption or prediction may result in the failure of the pair trading strategy.
This is a guide to Pairs Trading. Here we also discuss the definition and how does pairs trading work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –