Pair trading is a market-neutral trading strategy that involves the simultaneous buying and selling of similar (correlated) assets.
This method can be equally successfully applied both in the foreign exchange and in the stock market, as well as in the commodity market. The most difficult element of this type of trading is asset selection.
In this article, we will talk about the basic principles of pair trading, the basic methods of selecting instruments for it, and also give examples of its use in the real market.
What is the essence of pair trading?
Pairs Trading Is a trading strategy based on simultaneous multidirectional trading of two correlated financial instruments.
Correlation is the statistical relationship of two or more quantities (assets). It can be direct and reverse. In the first case, the price movement of one asset practically repeats all price movements of the other. With an inverse correlation, trading instrument charts look mirrored.
As an example of a direct correlation, we can take the behavior of oil prices and oil stocks. When oil prices rise, so do stocks. If the opposite situation arises – a fall in prices – the value of these assets will also correlate with each other, but in the direction of the fall.
However, each of the shares of oil companies will rise or fall in its own way, some of them more, some less. This temporary divergence in the prices of correlated stocks can be used for pair trading.
The pair trading strategy uses the principle of equilibrium, according to which periodically arising divergences of consistently correlated instruments tend to return to their usual mean values. Such discrepancies most often arise due to significant fundamental events (changes in Central Bank rates, corporate events, etc.).
The essence of the strategy is to identify a pair of financial instruments with a high degree of correlation, one of which has significantly increased or decreased in price relative to the other. After that, the sale of the overvalued asset is carried out and the simultaneous purchase of the undervalued one.
Thus, a market-neutral portfolio is formed from two oppositely directed positions, the profitability of which will depend not on the general direction of the market movement, but on the change in the price difference between these two instruments. It is expected that after some time the correlation will recover and the price ratio will return to its previous values, after which both positions can be closed.
How to choose instruments for pair trading?
The choice of assets for this strategy involves the use of fundamental and technical analysis, as well as statistical calculations. In general, you can start looking for pair trading tools among:
- Shares of companies belonging to the same market sector.
- Contracts for similar goods: Brent and WTI crude oil, gold and silver, etc.
- Currencies that have a certain relationship.
A popular way to assess the relationship of two instruments is to calculate the Pearson correlation. The stronger the correlation of assets, the more likely they are to move in the same direction. Also used is such a concept as cointegration – a statistical property of two or more variables that shows the stability of their relationship.
In this article, we will not go deep into mathematical calculations, but use graphical analysis to select correlated instruments. At the same time, you need to understand that this is only one of the ways to select assets for pair trading and it is not the most accurate.
First, we need to display the selected instruments on one chart. To do this in the MetaTrader platform, you will need to find and install special scripts and indicators. But also for this purpose, you can simply use specialized Internet resources, for example, TradingView.
By combining the quotes of two assets on one chart, we can visually assess their correlation in the available time period. The change in the price difference for these assets – the spread – is the main reference point for making trading decisions. Its average value is taken as a basis, and the emerging abnormal deviations (narrowing or divergence) are used for trading. In the figure below, to assess the correlation, the graphs of two oil brands are combined: Brent and WTI.
Examples of using pair trading
Let’s look at a few examples of using pair trading in various markets.
Pair trading can be used to trade stock indices and stocks of companies operating in the same or related sectors of the economy. Events occur periodically that can lead to violations of the correlation of prices of such assets, for example, the conclusion of large contracts or the development of new products. Also, the general mood of the stock market has a significant impact on quotes.
- The chart compares the quotes of the oil companies Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX).
- Stocks show a high correlation in history, the average spread of this pair is about $ 40.
- In early 2020, in the wake of falling stock markets and oil prices, the spread narrowed by half, to $ 20. At this point, one could buy Chevron shares and sell the same number of Exxon Mobil shares at the same time, expecting the spread to return to average values.
- After 2-3 months, the spread returned to its average value of $ 40, closing both positions would bring a profit of $ 20 per share.
For pair trading, you can take contracts for similar goods, for example, oil and natural gas, gold and silver. You can also use different types of contracts for the same product.
- The chart contains the quotes of the XAU / USD gold spot contract and the GC gold futures.
- Contracts have a very high correlation, usually the spread fluctuates around $ 10.
- Last year, in the wake of the crisis, the spread widened to an anomalous value of $ 60. At that moment, it was possible to sell GC futures that ran ahead and at the same time buy the corresponding amount of XAU / USD spot gold.
- After 2 weeks, the spread returned to $ 10, closing both positions would bring a profit of $ 50 per contract.
On Forex, for pair trading, you need to select two similar currency pairs. For example, EUR / USD and GBP / USD are positively correlated. However, this dependence is unstable, due to which the graphs of pairs can diverge over a very large distance and do not converge back for a long time. Basically, trading the EUR / USD and GBP / USD spread is similar to trading their EUR / GBP cross. When a stable trend emerges in EUR / GBP, the correlation between EUR / USD and GBP / USD is broken.
- The chart combines the quotes of the EUR / USD and GBP / USD currency pairs.
- These pairs are moderately correlated, the average spread on the chart is around 0.1500, which corresponds to 1,500 pips.
- Last year, during the fall of markets and the flight of investors into defensive assets, the spread narrowed by half, to 0.0750, which corresponds to 750 points. At that moment, one could buy a heavily sagging GBP / USD pair and at the same time sell the same volume at EUR / USD.
- A month later, the spread returned to the 0.1500 level, and closing both positions would bring a profit of 0.0750, that is, 750 pips.
Risk Management in Pair Trading
As with any other trading strategy, in pairs trading, you need to control the risks. And although the position is market neutral, unexpected news that affects one of the assets of the traded pair can dramatically change the speed and direction of the spread. Therefore, it is necessary for yourself to formulate in advance the criteria for limiting losses.
Since the strategy depends on changes in the size of the spread, setting Stop Loss for each symbol of the pair will be irrelevant. Alternatively, you can focus on the total loss for both positions. It is necessary to determine in advance an acceptable amount of risk per trade (for example, 3% of the capital), and if the total loss on positions reaches this value, close them.
Pair trading is a popular market neutral trading strategy. It may seem simple only at first glance. To be successful, a trader will need to be able to find the right tools, use statistics correctly and choose the best moment for transactions.
Risk management rules must also be followed. Before risking real capital, you should test your pair trading skills on a demo account.