Concept of Pair Trading
What is a Pair Trading ?
- Pair Trading is a market-neutral trading strategy that involves the simultaneous buying and selling of two correlated or related financial instruments.
- Traders identify two assets that historically move in tandem and take positions based on the expectation that the spread between the assets will converge or diverge.
- The strategy aims to profit from the relative performance between the two assets, regardless of the overall market direction.
How Pair Trading is done ?
- Lets take two hypothetical stocks, Company A and Company B.
- Let's say in the past Company A and Company B have shown a strong correlation in their price movements.
- However due to some market conditions there is an imbalance in their prices.
- If earlier the ratio of the prices of Company A to Company B is around 1:1, but due to some market conditions it shifts to 2:1.
- A trader may recognise the abnormal ratio of 2:1 compared to the usual 1:1.
- Trader may Sell short Company A while simultaneously buying Company B.
- and wait for the prices of the two stocks to converge back to their usual ratio of 1:1.
- When prices revert to their typical ratio of 1:1, the trader can close their positions by buying back Company A and by selling Company B.
- The goal is to profit from the convergence or divergence of the two assets rather than relying on the overall market direction.
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Pair trading can be done in various types of securities:-
1. Stocks : Pairs of individual stocks within the same sector or industry that typically exhibit a high correlation.
2. ETFs : ETF pairs that track similar indices, sectors, or commodities.
3. Options : Pair trading using options on related securities, employing strategies such as a put-call parity or a ratio spread.
4. Futures : Futures contracts on correlated assets like commodities, indices, or currencies.
5. Bonds : Pairs of bonds with similar maturities or credit ratings.
Note:- Stocks suitable for pair trading typically exhibit a strong historical correlation, often found within the same sector or industry.
For eg. Coca-Cola and Pepsi, Apple and Microsoft, General Motors and Ford.
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Pair Trading requires a deep understanding of statistical analysis, risk management, and market dynamics to identify suitable pairs and execute trades effectively.
It's crucial to continuously adjust the position/strategies as per changing market conditions to succeed in pair trading.
Lets understand the step by step process of how Pair Trading is done:-
1. Pair Selection:
Identify two correlated securities by thorough research and statistical analysis to find assets that historically move in tandem.
2. Statistical Analysis:
Perform statistical analysis to establish the relationship between these pair of assets.
Determine the mean, standard deviation and historical correlation to understand their typical behavior.
3. Deviation Identification:
Wait for a deviation from the established relationship due to some market conditions or other factors, which may lead to an imbalance in their price.
4. Entry Signal:
Utilise technical indicators (RSI etc) or statistical data to identify entry points when the deviation is significant enough to suggest a pair trading entry.
5. Position Sizing and Execution:
Take positions by buying the undervalued asset and selling short the overvalued asset.
Determine the appropriate size of each position based on factors like volatility, historical relationship, and risk tolerance.
6. Monitoring and Reversion:
Monitor the positions closely, expecting the prices of the paired assets to revert or converge back to their historical relationship.
Plan exit points for potential profits or to limit losses.
7. Risk Management:
Implement risk management strategies by setting stop-loss orders, diversifying positions, and adapting the position size based on market conditions.
8. Exit Strategy:
Exit the trade by booking profit when the prices revert to their typical relationship, achieving the expected convergence.
If the trade moves against expectations, consider reassessing the positions and exiting to limit losses.
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Advantages and Disadvantages of Pair Trading:-
Advantages of Pair Trading:-
1. Market-Neutral Strategy: It aims to profit from the relative performance between two assets, irrespective of the overall market direction.
2. Diversification: It provides a way to diversify risk by trading two correlated assets simultaneously (hedge).
3. Reduced Market Risk: Since it's based on relative performance, pair trading can reduce market risks that affect both assets in the same way.
4. Opportunity in Market Inefficiencies: It capitalises on temporary mispricings or deviations from the historical relationship between assets.
Disadvantages of Pair Trading:-
1. Correlation Risk: Unexpected changes in the historical correlation between the paired assets can result in losses.
2. Entry Challenges: Timing the entries and exits for both positions simultaneously can be challenging.
3. Unforeseen Events: Sudden events impacting one asset more than the other can disrupt the expected convergence or divergence.
4. Leverage and Margin Risks: Leveraging positions can magnify losses if the trade moves against expectations.
5. Commissions and Costs: The need for frequent trading due to short-term price movements can lead to higher transaction costs.
Note:
Pair trading requires a strong understanding of statistical analysis, risk management, and a consistent approach to identify and capitalise on mispricing between the selected assets.
Traders need to remain vigilant and adaptable to changing market conditions to effectively employ this strategy.
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An example of achieving market neutrality:-
Stock A and Stock B are generally at 100 each (as per historical data), (ratio 1:1).
But now due to some market conditions Stock A is 100 per share & Stock B is 200 per share (ratio 1:2).
Pairs trade: Buy 200 shares of Stock A for 20,000 & Sell 100 shares of Stock B for 20,000 (Net Buy/Sell = 0).
This is a true market-neutral position.
case 1 is if both stocks rise 50 percent: Stock A will be 150 per share & Stock B will be 300 per share (Net Profit/Loss = 0).
case 2 is if both stocks fall 50 percent: Stock A will be 50 per share & Stock B will be 100 per share (Net Profit/Loss = 0).
case 3 is if stocks A fall 50 percent & Stock B rise 50 percent: Stock A will be 50 per share & Stock B will be 300 per share (Trading Pair in Loss - need Adjustment or Exit to minimise Losses).
case 4 (as per our expectation) is if stocks A rise 50 percent & Stock B fall 50 percent: Stock A will be 150 per share & Stock B will be 100 per share (Trading Pair in Profit - Book Profit).
So out of 4 Case/Conditions only one case (Case 3) need adjustment.
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ABOVE SHARED EXPLANATION OF PAIR TRADING IS FOR EDUCATIONAL PURPOSE ONLY. YOU MAY BUILD YOUR OWN STRATEGY & PAPER TRADE TO GAIN CONFIDENCE AND BUILD FURTHER ON THESE.
Hope this helps :-)
Tc Happy Trading.
- Pair Trading is a market-neutral trading strategy that involves the simultaneous buying and selling of two correlated or related financial instruments.
- Traders identify two assets that historically move in tandem and take positions based on the expectation that the spread between the assets will converge or diverge.
- The strategy aims to profit from the relative performance between the two assets, regardless of the overall market direction.
How Pair Trading is done ?
- Lets take two hypothetical stocks, Company A and Company B.
- Let's say in the past Company A and Company B have shown a strong correlation in their price movements.
- However due to some market conditions there is an imbalance in their prices.
- If earlier the ratio of the prices of Company A to Company B is around 1:1, but due to some market conditions it shifts to 2:1.
- A trader may recognise the abnormal ratio of 2:1 compared to the usual 1:1.
- Trader may Sell short Company A while simultaneously buying Company B.
- and wait for the prices of the two stocks to converge back to their usual ratio of 1:1.
- When prices revert to their typical ratio of 1:1, the trader can close their positions by buying back Company A and by selling Company B.
- The goal is to profit from the convergence or divergence of the two assets rather than relying on the overall market direction.
//------------------------------------------------------------------------------------------------------------------
Pair trading can be done in various types of securities:-
1. Stocks : Pairs of individual stocks within the same sector or industry that typically exhibit a high correlation.
2. ETFs : ETF pairs that track similar indices, sectors, or commodities.
3. Options : Pair trading using options on related securities, employing strategies such as a put-call parity or a ratio spread.
4. Futures : Futures contracts on correlated assets like commodities, indices, or currencies.
5. Bonds : Pairs of bonds with similar maturities or credit ratings.
Note:- Stocks suitable for pair trading typically exhibit a strong historical correlation, often found within the same sector or industry.
For eg. Coca-Cola and Pepsi, Apple and Microsoft, General Motors and Ford.
//------------------------------------------------------------------------------------------------------------------
Pair Trading requires a deep understanding of statistical analysis, risk management, and market dynamics to identify suitable pairs and execute trades effectively.
It's crucial to continuously adjust the position/strategies as per changing market conditions to succeed in pair trading.
Lets understand the step by step process of how Pair Trading is done:-
1. Pair Selection:
Identify two correlated securities by thorough research and statistical analysis to find assets that historically move in tandem.
2. Statistical Analysis:
Perform statistical analysis to establish the relationship between these pair of assets.
Determine the mean, standard deviation and historical correlation to understand their typical behavior.
3. Deviation Identification:
Wait for a deviation from the established relationship due to some market conditions or other factors, which may lead to an imbalance in their price.
4. Entry Signal:
Utilise technical indicators (RSI etc) or statistical data to identify entry points when the deviation is significant enough to suggest a pair trading entry.
5. Position Sizing and Execution:
Take positions by buying the undervalued asset and selling short the overvalued asset.
Determine the appropriate size of each position based on factors like volatility, historical relationship, and risk tolerance.
6. Monitoring and Reversion:
Monitor the positions closely, expecting the prices of the paired assets to revert or converge back to their historical relationship.
Plan exit points for potential profits or to limit losses.
7. Risk Management:
Implement risk management strategies by setting stop-loss orders, diversifying positions, and adapting the position size based on market conditions.
8. Exit Strategy:
Exit the trade by booking profit when the prices revert to their typical relationship, achieving the expected convergence.
If the trade moves against expectations, consider reassessing the positions and exiting to limit losses.
//------------------------------------------------------------------------------------------------------------------
Advantages and Disadvantages of Pair Trading:-
Advantages of Pair Trading:-
1. Market-Neutral Strategy: It aims to profit from the relative performance between two assets, irrespective of the overall market direction.
2. Diversification: It provides a way to diversify risk by trading two correlated assets simultaneously (hedge).
3. Reduced Market Risk: Since it's based on relative performance, pair trading can reduce market risks that affect both assets in the same way.
4. Opportunity in Market Inefficiencies: It capitalises on temporary mispricings or deviations from the historical relationship between assets.
Disadvantages of Pair Trading:-
1. Correlation Risk: Unexpected changes in the historical correlation between the paired assets can result in losses.
2. Entry Challenges: Timing the entries and exits for both positions simultaneously can be challenging.
3. Unforeseen Events: Sudden events impacting one asset more than the other can disrupt the expected convergence or divergence.
4. Leverage and Margin Risks: Leveraging positions can magnify losses if the trade moves against expectations.
5. Commissions and Costs: The need for frequent trading due to short-term price movements can lead to higher transaction costs.
Note:
Pair trading requires a strong understanding of statistical analysis, risk management, and a consistent approach to identify and capitalise on mispricing between the selected assets.
Traders need to remain vigilant and adaptable to changing market conditions to effectively employ this strategy.
//------------------------------------------------------------------------------------------------------------------
An example of achieving market neutrality:-
Stock A and Stock B are generally at 100 each (as per historical data), (ratio 1:1).
But now due to some market conditions Stock A is 100 per share & Stock B is 200 per share (ratio 1:2).
Pairs trade: Buy 200 shares of Stock A for 20,000 & Sell 100 shares of Stock B for 20,000 (Net Buy/Sell = 0).
This is a true market-neutral position.
case 1 is if both stocks rise 50 percent: Stock A will be 150 per share & Stock B will be 300 per share (Net Profit/Loss = 0).
case 2 is if both stocks fall 50 percent: Stock A will be 50 per share & Stock B will be 100 per share (Net Profit/Loss = 0).
case 3 is if stocks A fall 50 percent & Stock B rise 50 percent: Stock A will be 50 per share & Stock B will be 300 per share (Trading Pair in Loss - need Adjustment or Exit to minimise Losses).
case 4 (as per our expectation) is if stocks A rise 50 percent & Stock B fall 50 percent: Stock A will be 150 per share & Stock B will be 100 per share (Trading Pair in Profit - Book Profit).
So out of 4 Case/Conditions only one case (Case 3) need adjustment.
//------------------------------------------------------------------------------------------------------------------
ABOVE SHARED EXPLANATION OF PAIR TRADING IS FOR EDUCATIONAL PURPOSE ONLY. YOU MAY BUILD YOUR OWN STRATEGY & PAPER TRADE TO GAIN CONFIDENCE AND BUILD FURTHER ON THESE.
Hope this helps :-)
Tc Happy Trading.
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