Pair trading is a market neutral strategy that enables a trader to profit from virtually any market condition – both trending and non-trending. This strategy involves the simultaneous matching of a long position with a short position in a pair of highly correlated instruments such as two stocks, currencies or commodities. Pair traders monitor the price performance of two historically correlated instruments. When the correlation between the two instruments temporarily weakens – one moves up while the other moves down – a trader shorts the outperforming asset and goes long on the underperforming one, betting that the “spread” between the two would converge over time. In pair trading, profit is realized from the difference in price change between the two instruments, rather than from the direction in which each asset moves. Hence, a profit can be achieved if the long position goes up more than the short, or the short position goes down more than the long.
How to Find Pair Trading Candidates?
• The first step is to identify a pair of instruments whose prices have the propensity to move together with good liquidity. Most binary options brokers offer a variety of pairs to trade in.
• Next, we need to determine the level of correlation between the two assets. Most trading platforms have technical indicators that can automatically plot the degree of correlation on the price charts.
• If the assets’ price movements are indeed correlated, we need to ascertain if the relationship is mean reverting, i.e. when prices diverge, do they revert to the statistical mean. This can be established by calculating the pair’s price ratio, which is defined as the price of one instrument divided by the price of the other. The price ratio should generally come out to be roughly the same number, within a very small range.
• Finally, look for events that trigger weakness in correlation between the two instruments. Examples include Federal Reserve announcements or major geopolitical turmoil.
A Simple Example
Lowe’s Companies, Inc. (NYSE:LOW) and The Home Depot, Inc. (NYSE:HD) operate in the same business segment, and are two highly correlated stocks, as depicted by the following chart. When the price ratio fell to three standard deviations below the statistical mean, we buy Lowe shares at $29.50 and short sell Home Depot t at $38.99. A month later, we exited the position when the ratio returned to mean, by selling Lowe at $26.50 and covering the short position in Home Depot at $31.80. Our Lowe long trade ended with a 10.1% loss, but the Home Depot short yielded an 18.5% gain, resulting in a nice net profit of 8.4% in little over a month’s time.
Advantages of Pair Trading
Pair trading has several advantages, some of which are listed below.
1. Market Neutral Strategy: The most attractive feature of pair trading is the ability to profit irrespective of the current state of the market. Since this strategy does not depend on market direction, trades can successfully be executed during uptrends, downtrends, or sideways movements.
2. The Risk is Controlled: Because a long position is always simultaneously matched with a short position, a pair trade automatically creates a hedge, which helps in controlling the market risk.
3. Shields from Adverse Directional Movement: In pairs trading, since the second instrument acts as a hedge against the first, directional risk is removed. Profit depends exclusively on the difference in price change between the two instruments.
4. Smaller Drawdowns: Managing drawdowns is an essential part of any profitable trading strategy. Pair strategies generally involve smaller net drawdowns because losses from a losing position are always tempered by gains from the winning position.
Successful pair trading requires well-researched strategies, based on accurate historical modelling. Binary options traders should be able to identify truly correlated pairs, locate high-probability trading setups, and use proper position sizing techniques to reap the maximum benefits.