Pairs Trading Definition
A pairs trading can be defined as a trading strategy that uses both statistical as well as technical analysis and involves the pairing of long and short position on stocks that are strongly correlated with one another for the purpose of ploughing higher rate of profits irrespective of the direction in which the market is moving.
This strategy remains un-impacted by the direction in which the market is moving. This type of strategic option of trading is a combination of both long positions as well as 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 for the purpose of generating potential returns that are market neutral in nature.
How does Pairs Trading Work?
Pairs trading strategy assumes that there is neutrality in the market, or in other words, both the securities will move and will continue to move in a similar fashion as it used to do earlier. This means that the traders participating in this strategy will search for high correlated securities.
These securities can belong to one industry, and sometimes direct competitors too. These high correlated securities might start diverging in their respective price movements, and it can occur for a few minutes or weeks or months as well 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, or 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 securities that are over-performing to fall in the nearing time.
Pairs Trading Example
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 the stocks will bounce back to its high positive correlation.
Pair Trading Strategy
The historical correlation of both stocks is the basis of a pair trading strategy. The key driver of this strategy could be the fact 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..
In case a trader detects a discrepancy pertaining to correlation, he or she 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, then he or she 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 down, whereas they can keep the long stock as its prices are expected to move up.
Difference Between Pairs Trading and Statistical Arbitrage
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 it has become quite popular in hedge funds as well as 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 that are traded only for a shorter period of time.
- Helps in the mitigation of risks– It can help in the mitigation of risks as it deals in trading of two securities, which means even if one is underperforming, then 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– It ensures that the trader is earning 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.
- Price Filling: Generating profits in pairs trade relies on margins that are too narrow, and transactions are required to be done in large volumes, which indicates that there is a high rate of risk that the stock orders will not be filled at an expected price.
- Commissions: Pairs trading is highly discouraged by a few traders due to the fact that it demands them to pay a higher rate of commission. A single pair of trading might sometimes require the trader to pay twice the commission for a standard trade. For traders that are operating on narrow margins, the difference in commission would be the difference between gains and losses.
In a pair trading concept, whatever way 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.
To conclude, it can be said that pairs trading is one of the 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 actually moving. The strategy can even fail if the correlation between securities is not evaluated properly.
This has been a guide to Pairs Trading and its definition. Here we discuss how pairs trading strategy works with an example and compare it with Statistical Arbitrage. You may also have a look at the following articles –