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.

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 neutral. This strategy remains unimpacted by the direction in which the market is moving.

Table of contents

• Pairs Trading Definition
  • How does Pairs Trading Work?
    • Pairs Trading Example
  • Pair Trading Strategy
  • Difference Between Pairs Trading and Statistical Arbitrage
  • Advantages
  • Disadvantages
  • Conclusion
  • Recommended Articles
• 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.

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.

Let us look at the 52-week chart below to understand the concept better. 

Source

If individuals follow the price movements shown in the above chart, they can find that the two stocks — Stock A and Stock B have a high correlation, which is the main requirement for this strategy. Precisely, the technique is dependent on the two securities’ price divergence or convergence. As one can observe, a price divergence appeared around the twentieth week. Per the strategy, one would short sell Stock A and long buy Stock B, and then when the prices converge, as shown in the chart, they need to reverse their previously held position. Thus, in simple terms, the idea is to generate profits from the stocks’ relative price movements. 

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.

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 correlation 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 correlation.

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 selling it as its prices are expected to fall, whereas they can keep the long stock as its prices are expected to increase.

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.

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.

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 markets, 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.

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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 –

• Program Trading
• Top Careers in Trading
• Quantitative Trading Definition
• Position Trading