Pair Trading Logic

26 Aug, 2021

6 min read

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In order to better understand pair trading, it is important to first understand where it comes in handy, i.e., in rule based trading. Rule based trading – also referred to as quants, is used by traders who employ a number of complex mathematical models to trade a number of varied securities.

A Brief Overview

Although these algorithms are on occasion used by high-frequency traders that employ speedy computers with fast internet connections, you are capable of creating algorithms that work for longer time frames. 

Within this backdrop, pair trading stocks can be understood to be a trading strategy that makes use of a long position being matched with a short position keeping in mind two stocks that have a high correlation to one another. 

How Pairs Trade Work

The strategy of pairs trading emerged in the mid-1980s and gained prominence among a set of technical analyst researchers that were employees of Morgan Stanley, a multinational investment bank that offers financial services. This pair trading strategy makes use of statistical analysis interspersed with technical analysis to discern the possibility of market-neutral profits.

Market neutral strategies incorporate a significant section of a pairs trade transaction. They make use of long and short positions that exist keeping in mind two separate securities that have a positive correlation. The two diverse positions that offset one another set the foundation for a hedging strategy that hopes to take advantage of either a negative or a positive trend.

Understanding the Scope of a Pairs Trade 

When you make use of a pair’s trading strategy, you seek to make sure it is based on the historical correlation that exists between any two securities. The basic premise that underlies this is that the two securities selected for a pairs trade have a strong positive correlation as this is the main force that helps secure profits under this strategy. This strategy is most useful when a trader is able to identify a correlation discrepancy. Keeping in mind the previous trajectory that the two securities in question will continue on with a certain correlation, the pairs trade can be made use of when this correlation flounders.

When pairs from such a trade eventually part ways – provided the investor is making use of a pair’s strategy – they would be able to seek out a rupee in sync with the long position in the underperforming security. Furthermore, the investor would sell short the security that outperforms. Should the securities return to their prior correlation, a profit is in the making owing to the convergence of the prices.

Pros and Cons of Employing a Pairs Trade 

Provided a pair’s trade performs in accordance with what was expected, the investor in question profits from the same. This is owed to the fact that the investor is able to remove potential hurdles mid-way that might otherwise have led to losses.

Profits are created in instances of the underperforming security regaining its value and the outperforming security’s price begins to drop. The net profit derived is via the gap that persists between these two positions.

That being said, there are limitations that prevent pairs trading. For starters, a pair’s trade is heavily dependent upon a strong statistical correlation between two securities. For the vast majority of pairs trades, a statistical correlation of 0.80 is required which can be hard to come by.

Furthermore, although historical trends can hold true, past prices don’t always accurately relay future trends. Requiring and solely being dependent upon a correlation of 0.80 may also diminish the chances of the expected outcome holding true.

Applying the Pair Trading Logic

In order to understand this strategy thoroughly, consider the example below that applies pair trading logic. 

Consider Stock ABC and Stock XYZ that have a strong correlation amounting to 0.9. In the short=term, the two of these stocks deviate from their previously trending correlation and reach a correlation of 0.5.

As an arbitrage trade, you decide to match a rupee to the long position of underperforming Stock ABC and hold a short position for the outperforming Stock XYZ. Ultimately, the stocks begin to converge such that they return to their previously existing correlation of 0.9. As a result, you profit from both, the long position, as well as the closed short position.

Conclusion

It is important to understand how the market operates prior to investing in any investment tools.

FAQs

Q1. What are pair trading stocks?
A1. Pair trading stocks refer to a trading strategy that makes use of a long position being matched with a short position keeping in mind two stocks that have a high correlation to one another.

Q2. Name a pro associated with pair trading.
A2. Pair trading has several benefits, one of them being that if a pair’s trade performs as expected, the investor stands to profit from the same. This is owed to the fact that the investor is able to remove potential hurdles mid-way that might otherwise have led to losses.

Q3. Name a con associated with pair trading.
A3. A drawback associated with pair trading is that a pair’s trade is heavily dependent upon a strong statistical correlation between two securities.

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