If you have been trading markets for a while, there is a chance you have heard of pairs trading. It’s a market-neutral trading strategy that a trader can employ to profit from the temporary mispricing of two or more securities, as long as they are highly correlated. However, the first challenge to successfully deploying this strategy lies in identifying two securities that have a high positive correlation.
In other words, two securities that tend to move in tandem. When the price of one security diverges from the other, the trader can enter a trade to profit from the expected convergence of the two prices.
Let’s say the trader identifies two stocks that are highly correlated such as Nvidia and Intel. If Nvidia’s stock price suddenly rises while Intel’s stock remains unchanged, the trader can enter a trade to short Nvidia and buy Intel. By doing this, the trader is betting that the prices of the two stocks will eventually converge, at which point the trader can proceed to close out the trade and profit from the difference in prices.
That said, pair trading is a relatively low-risk strategy since it is market-neutral. As a trader, you are not exposed to the overall direction of the market. Therefore, if the market goes up, you will not only not make a profit but also not lose money. On the other hand, if the market goes down, you will make a profit as long as the two securities converge. Now the big question is: how to pairs trade?
Getting Started With Pairs Trading
As mentioned earlier, pairs trading can be a profitable strategy. However, the greatest challenge lies in selecting two securities with the highest correlation. Also, as a trader, you will need to be able to identify when the prices of the two securities diverge. Not to mention the ability to time the trade correctly if you are to stand a chance of profiting from the convergence of the prices.
That said, to choose a pair, you have to consider a few things. The first is a high positive correlation. A correlation coefficient of 0.8 or higher is a great choice here. The other is that the two must have a similar price ratio, meaning the price of one security should be a multiple of the price of the other security. In simple terms, if one security is trading at £100 and the other is at £50, the price ratio here is 2:1.
What Else To Consider?
Other factors to consider include liquidity and volatility. The two securities must be liquid, meaning that they are traded frequently and boast a large number of shares available for trading. This way, you can enter and exit the trade without significantly impacting the prices of the securities. Also, they should have a similar level of volatility in that they move up and down in price by a similar amount. This way, the prices of the securities can converge in a reasonable amount of time.
Additionally, to find highly correlated securities, you can consider the industry they are based in. Securities from the same industry are likely to be more correlated than those from other industries. Also, if they share fundamentals such as market cap, debt levels, and dividend yields, they are likely to be more correlated. Most importantly, you can employ technical analysis to identify trading opportunities in pairs trading.
Example Of A Pairs Trade With Stocks
There are several good examples of stocks that can be pair-traded. For instance, Coca-Cola and Pepsi both serve the same industry. Let’s say they boast a correlation coefficient of 0.95 and a price ratio of 2:1. You can enter the trade if the price of Coca-Cola is £100 and that of Pepsi is £50 by shorting 100 shares of Coca-Cola to buy 50 shares of Pepsi. As for the exit, you will have to wait for the price ratio to return to 2:1.
For instance, if Coca-Cola drops to £90 and Pepsi drops to £45, the price ratio would be 1.8:1. You can close the trade by buying back the 100 shares of Coca-Cola and selling the 50 shares of Pepsi. Your profit would be the difference between the price ratio at the entry price and the price ratio at the exit. In our example, that would be (2.0 – 1.8)*100 = 100.
Final Thoughts
Pairs trading has quickly gained in popularity among investors as an effective strategy to manage risks in volatile markets. By pairing together two highly correlated securities, traders can take advantage of temporary mispricing’s while profiting from eventual price convergences. Pairs trading offers traders an attractive market-neutral strategy that allows them to withstand overall market movements with minimal exposure.
But successful implementation requires careful selection of correlated securities, carefully timing trades, consideration of liquidity and volatility factors and taking other factors into account. Pairs trading can be an immensely profitable addition to a trader’s arsenal, providing opportunities to navigate complex market conditions more confidently and increase potential profits.
What is a Bull and Bear Market?
A bull market refers to a period of time in the financial market where prices of securities, such as stocks, are rising or expected to rise. It typically reflects investor optimism, positive economic indicators, and strong market performance. During a bull market, investors are more willing to invest, driving up prices and generating high levels of buying activity.
Conversely, a bear market refers to a period of time when prices of securities are falling or expected to fall. It is characterized by pessimism, negative economic indicators, and declining market performance. In a bear market, investors are more likely to sell their investments, leading to a decrease in prices and a higher level of selling activity.
The terms “bull” and “bear” are derived from the way these animals attack. Bulls thrust their horns upwards, symbolizing a rising market, while bears swipe their paws downwards, representing a declining market.
