Pairs Trading Strategies: A Detailed Overview

It is important that you closely monitor news affecting the companies you choose. We might utilise this knowledge to construct some rules for our hypothetical strategy. If we see the ratio rising to the higher end of the range, we sell Anglo American and buy Antofagasta. The higher end of the range is about 2.4 (although we do have a spike close to 2.9 in February 2022) and the lower end is roughly 1.6. We also see a tendency for the ratio to revert to the mean level, which is around 2.1). Antofagasta/Anglo American is one of the pairs with a high correlation value; let’s run with this pair to illustrate a hypothetical strategy.

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For instance, if a trader shorted Coca-Cola and went long on Pepsi, they would close both positions once Coca-Cola’s price drops and Pepsi’s price rises back to their usual relationship. But if Coca-Cola’s stock suddenly rises while Pepsi’s remains the same, a trader might assume that the price difference is temporary. They would short sell Coca-Cola (betting that its price will go down) and buy Pepsi (betting that its price will go up). Now, look at a price chart (the top half of figure 1) to see how these correlations come into play. When prices de-correlate (red circles and boxes), notice how the price spread between KO and PEP widens.

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If relying on manual research, the results of this inquiry constitute the list; if relying on a model, the model’s output serves as the list of candidates. A trader who intends to hold a given position for several hours to several days will need to generate candidate trades with far greater frequency than a manager whose average holding period is measured in months. This style of investing gives us greater flexibility to express our views across both rising and falling markets. It means we can generate alpha from both sides of the ledger without increasing overall market exposure.

Assumptions and Risks of Pairs Trading

While pairs trading is a well-known market-neutral strategy, it is often confused with statistical arbitrage. Both approaches use statistical relationships to identify trading opportunities, but they differ in complexity, execution, and the number of assets involved. With straightforward methods of trading, you take a position in a financial instrument and gain exposure to its price.

Pairs trading offers a structured, market-neutral approach to trading, making it attractive to many traders. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. A major assumption of the strategy is that the historical price relationship will continue to hold in the future. Hand in hand with this is an assumption that when the price ratio diverges away from the mean, it will revert with time. There is an approach, however, that seeks to mitigate market risk while aiming to make a profit from pricing discrepancies.

It’s all relative (value): The art and science of pairs trading

Pairs trading is a market-neutral strategy that can entice traders looking for profits by coupling long and short positions in two correlated stocks. Originating from the mid-1980s, this strategy demands an understanding of historical correlation data and technical analysis. While pairs trading offers an opportunity to profit when stock prices deviate from their historical correlation, it also comes with risks. A key consideration for traders is ensuring the stocks maintain a high positive correlation, typically 0.80 or above. Pairs trading involves simultaneously taking a long position with a short one in two highly correlated stocks. Developed in the 1980s by Morgan Stanley, the strategy aims for market-neutral profits through statistical and technical analysis.

As an illustration, you might expect adverse changes in UK financial regulations to negatively affect both, or a pickup in demand for banking services to boost both. A classic example of this would be two companies operating in the same industry, doing similar lines of business, in the same general locations and selling to similar types of clients. For example, this could mean UK banks, German automotive manufacturers or US telecoms. A starting point would be to investigate two instruments that we might reasonably expect to have some degree of correlation between their prices. Price relationships between instruments are always changing and can also be impacted by higher level macroeconomic factors. This article is intended for educational purposes only and not as an endorsement of a particular financial strategy, company, or fund.

It has been widely used by professional traders and hedge funds due to its relatively low risk, as it doesn’t depend on the overall market direction. Instead, it exploits the relative price movement between two assets, seeking to capitalize on price discrepancies. If the securities return to their historical correlation, a profit is made from the convergence of the prices. Pairs trading is a popular market-neutral trading strategy that helps traders profit from price differences between two related assets. Instead of betting on whether the market will go up or down, traders use pair trading to exploit temporary imbalances between two highly correlated stocks, forex pairs, commodities, or even cryptocurrencies. To measure these relationships, the pairs trader will use statistics, fundamentals, technical analysis, and even probabilities.

Because both positions are placed simultaneously, market-wide price movements have less impact on the overall trade.
All the trader cared about was that the stocks’ prices should revert to their usual price relationship—not jumping too far ahead or behind relative to the other.
Pairs trading is devised as a strategy that can work with any two correlated instruments.
While this would seem to be the most straightforward step in the investment process, there are a few subtleties.

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Look for highly correlated pairs, such as EUR/USD and GBP/USD (positive correlation) or EUR/USD and USD/CHF (negative correlation). Use correlation coefficients and historical Umarkerts Review price patterns to confirm their relationship. The successful execution of each of the steps is a critical element in the process of becoming a profitable pairs trader. As is the case with any trading methodology, the complexity and success of the final 3 steps, the actual trading, are integrally dependent on the care and skill that go into the first 3. Once a trader selects a pair, they monitor the price relationship between the two assets.

This approach typically requires access to real-time data and high-frequency trading strategies to capitalize on small price discrepancies. A pairs trade strategy is based on the historical correlation of two securities. The securities in a pairs trade must have a high positive correlation, which is the primary driver behind the strategy’s profits. A pairs trade strategy is best deployed when a trader identifies a correlation discrepancy. Relying on the historical notion that the two securities will maintain a specified correlation, the pairs trade can be deployed when this correlation falters.

And if their prices diverge, it can present a profit as prices converge back toward their correlated state.
A key assumption in pairs trading is that two assets will maintain a historical correlation.
There are many different types of technical and fundamental overlays that can be employed, from candlestick charting to relative strength.

One stock may significantly jump ahead or fall behind the other (i.e., fall out of correlation), but such anomalies have, historically, turned out to be short-term blips. Imagine two businesses operating in the same market, running the same strategies, and offering similar products. Although they’re competing with each other, their earnings and stock performance tend to move in sync. Second, while historical trends can be accurate, past prices are not always indicative of future trends. For instance, we include Tech and Healthcare within Growth, allowing us to pair stocks across two different sectors regardless of the industry they operate in.

The below chart does just that, and plots the ratio of the two share prices over a multi-year period. Short selling and margin trading entail greater risk, including, but not limited to, risk of unlimited losses and incurrence of margin interest debt, and are not suitable for all investors. Please assess your financial circumstances and risk tolerance before short selling or trading on margin. Margin trading is extended by National Financial Services, Member NYSE, SIPC, a Fidelity Investments company. The trader wasn’t betting on both stocks moving in any given direction, up or down. All the trader cared about was that the stocks’ prices should revert to their usual price relationship—not jumping too far ahead or behind relative to the other.

Likewise, they must be mindful of the pair’s price action and constantly adjust the risk/return profile of the trade. For example, if a trade with an expected duration of 3 weeks were to achieve 50% of its profit objective in the first day after execution, the trader will want to reevaluate the potential reward for keeping the trade open. In such a situation, the trader could choose 1 of 2 options to prudently manage the trade moving forward. The trade could be immediately closed with a view that the additional return does not warrant the risk or the opportunity cost.