Pairs Trading

Updated on January 4, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Pairs Trading?

A pairs trading can be defined as a trading strategy that uses both statistical and technical analysis and involves the pairing of long and short positions on stocks that are strongly correlated with one another for plowing higher rates of profits irrespective of the direction in which the market is moving.

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Pairs trading options are a combination of both long positions and short positions of stocks that are correlated with each other. It is a market-neutral strategy based on not just statistical but technical analysis as well solely to generate potential returns that are market neutralMarket NeutralMarket neutral is an investment strategy or portfolio management technique where an investor seeks to negate some form of market risk or volatility by taking long and short positions in various stocks to increase ROI achieved by gaining from increasing and decreasing prices from one or more than one market.read more. This strategy remains unimpacted by the direction in which the market is moving.

Key Takeaways

  • Pairs trading is a strategy that pairs long and short positions on stocks with a high degree of correlation to generate higher profit rates regardless of the market direction. It employs both statistical and technical analysis.
  • It is built on the historical correlation of both equities. This strategy’s primary motivator may be that the equities involved in it all have a greater rate of positive correlation.
  • It may assist in lessening or eliminating the risks associated with trading while enabling traders to make money regardless of market movement. It only succeeds if the relationship between the securities is correctly determined.

How does Pairs Trading Work?

In a pair trading concept, whatever the market may move, the correlated securities shall continue to move in the direction they were already moving. In the case of a long trade, underperforming correlated security shall rise in price, whereas, in the case of a short trade, over-performing correlated security shall fall in price.

Pairs trading strategy assumes neutrality in the market; in other words, both the securities will move and will continue to move similarly as they used to. This means that the traders participating in this strategy will search for highly correlated securities.

These pairs trading stocks can belong to one industry and sometimes direct competitors too. These highly correlated securities might start diverging in their respective price movements, and they can occur for a few minutes, weeks, or months in the long term.

Pair traders in a market neutrality concept expect the price of the securities that are not performing well at the moment to bounce back. In other words, they expect a rise in the price of their underperforming securities. Pair traders in a market neutrality concept also expect the price of the over-performing securities to fall soon.

It can be said that pairs trading is one of the most powerful tools of trading as it can help in the mitigation or minimization of risks associated with trading and even enables the traders to earn profits irrespective of how a market is moving. The strategy can even fail if the correlation between securities is not evaluated properly.

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Examples

Let us understand the concept of pairs trading options with the help of a couple of examples. These examples will help us understand the intricacies of the concept and its related factors.

Example #1

Isabelle, a trader in the stock market wanted to hedge the risks of a volatile market by adopting the pairs trading strategy. Therefore, she decided to invest in the automobile industry where the market leaders were companies ABS and CBA.

Many times, it was found that the direct competition between the two companies resulted in an inverse relationship in their movement in the stock market. However, they bounced back strongly due to the evergreen nature of their industry.

If ABC stock is correlated to CBA stock, where the former is up 20 points, and the latter is down 20 points, it can be assumed that both stocks will bounce back to their high positive correlation.

Example #2

An American branch of the global Cryptocurrency exchange, Binance.US came under the scanner of the Securities and Exchange Commission (SEC) on June 5, 2023, for allegedly violating U.S. securities laws.

As a result, Binance.US was directed to remove over 40 trading pairs from its platform. The majority of these pairs were linked to USDT. These corrective actions were incorporated in just three days after the lawsuit.

Pair Trading Strategy

Now that we understand the basics and a few practical implications, let us understand the strategy for trading pairs stocks and its historical correlation through the explanation below.

The historical correlationCorrelationCorrelation is a statistical measure between two variables that is defined as a change in one variable corresponding to a change in the other. It is calculated as (x(i)-mean(x))*(y(i)-mean(y)) / ((x(i)-mean(x))2 * (y(i)-mean(y))2.read more of both stocks is the basis of a pair trading strategy. The key driver of this strategy could be that the stocks participating in the same should necessarily have a higher rate of positive correlationRate Of Positive CorrelationPositive Correlation occurs when two variables display mirror movements, fluctuating in the same direction, and are positively related. In layman's terms, if one variable increases by 10%, the other variable grows by 10% as well, and vice versa.read more.

If a trader detects a discrepancy in correlation, they can choose to deploy this strategy. In other words, when a trader realizes that both the stocks are not correlated or if the correlation between the securities no longer exists, they can deploy the pairs trade. The traders can even get rid of the short stock by sellingShort Stock By SellingShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen.read more it as its prices are expected to fall, whereas they can keep the long stock as its prices are expected to increase.

Advantages

Let us discuss the advantages of trading pairs options through the points below.

  • Helps in the mitigation of risks– It can help in the mitigation of risks as it deals in the trading of two securities, which means even if one is underperforming, the other can absorb the losses. It helps in the minimization of trading risks arising as a result of movements in the market direction.
  • Guaranteed profits– The trader earns profits irrespective of the market condition. In other words, pair traders will be able to earn returns on trading no matter if the market is swinging sideways, losing, gaining, and so on.

Disadvantages

Despite the handful of advantages, there are factors from the opposite end of the spectrum that prove to be a hassle for traders and regulators. Let us understand the disadvantages of trading pairs stocks through the discussion below.

  • Price Filling: Generating profits in pairs trade relies on too narrow margins, and transactions are required to be done in large volumes, which indicates a high risk that the stock orders will not be filled at an expected price.
  • Commissions: Pairs trading is highly discouraged by a few traders because it demands them to pay a higher commission rate. A single trading pair might sometimes require the trader to pay twice the commission for a standard trade. For traders operating on narrow margins, the difference in commission would be between gains and losses.

Difference Between Pairs Trading and Statistical Arbitrage

Both pairs trading options and statistical arbitrage have been widely followed by traders, investors, and hedgers in the market. However, there are differences in their fundamentals and implications. Let us understand the differences through the comparison below.

Statistical arbitrage can be defined as a modified version of a pairs trading strategy. Statistical arbitrage or StatArb includes such trading strategies that are driven quantitatively. The ultimate objective of each strategy is to yield a higher rate of profits for the trading companies.

Statistical arbitrage is a medium-frequency strategy and not a high-frequency strategy. Statistical arbitrage is mostly applied in financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more, and has become quite popular in hedge funds and investment banks. Unlike pairs trading, statistical arbitrage is not confined to just two stocks or securities. Traders can apply the concept of statistical arbitrage in a variety of correlated stocks. Statistical arbitrage employs large and diverse portfolios traded only for a shorter period.

Frequently Asked Questions (FAQs)

Is pairs trading statistical arbitrage?

Investors frequently refer to statistical arbitrage as “pairs trading.” The use of statistical arbitrage is loosely restricted to two stocks. Investors can use a collection of related securities as a case study. Additionally, just because two stocks are active in different industries does not preclude the possibility of correlation.

What is the leading risk in pair trading?

One makes an 18% profit on the pair trade thanks to the 10% gain on the long position in gold and the 8% gain on the short part in silver. If both sides of the trade move in the opposite direction, one risks getting squeezed, which is a significant risk in pairs trading.

What is cointegration in pairs trading?

A long-term correlation between the prices of two or more assets is called cointegration. It may be considered a gauge of the similar two assets’ risk exposure profiles. Due to the spread’s stationarity, the prices of cointegrated assets are linked.

Recommended Articles

This has been a guide to what is Pairs Trading. Here we explain its strategy, examples, and advantages, and compare it with statistical arbitrage. You may also have a look at the following articles –

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