What is Pair Trading and what are its advantages
Pair trading is a trading strategy that combines long and short positions in a pair of two highly correlated instruments: stocks, futures, commodities, currencies or options. A characteristic feature of pair deals is that they are practically not affected by the general market trend. The reason for this is that when using this type of trading strategy, traders open a long trade in one asset and short in another, thus making the aggregate position market-neutral. That is why paire trading is also called a market-neutral trading strategy.
Let’s consider the main advantages and disadvantages of the pair trading strategy:
In any market conditions. The yield of the pair trading does not depend on the direction of the market movement, but is determined only by the price ratio between the two instruments: shares / commodities / currencies. Whereas in other trading strategies, the direction of the market is the main factor determining the outcome of the transaction, for the bargains the direction of the market does not matter – only the assets that are part of the pair determine the outcome of each transaction. This is one of the most attractive features of the pair trading.
Limited risk. In pair trading, the risk is always limited and known. The concept of a pair trading strategy is based on the balance of long and short positions of related assets, which automatically leads to the fact that the total position on the portfolio always remains hedged. This means that the portfolio risk remains limited and controlled.
Predictability. Predicting the price ratio of two highly correlated assets is always easier than the price of each of them individually, since the ratio of related assets always tends to a long-term balance, the behavior of which is much more stable than the price behavior. Indeed, even at the household level, we can fairly accurately say, for example, how much in percentage terms beef costs more than pork. At the same time, it will be much more difficult to predict the price of each of these products individually, since it will be influenced by too many factors, including even such as the magnitude of inflation, the dollar rate, sanctions, etc. Therefore, in paire trading, a more important step is to find and select good pairs, rather than the forecast itself.
Market volatility is not a problem. Traders are often afraid to trade in volatile markets, as frequent and unpredictable price fluctuations confuse forecasts, disrupt “stops” and significantly increase risks. At the same time, when using paired trading, high volatility on the contrary allows you to earn more, because the more often the prices of instruments will converge and diverge, and the more the magnitude of these discrepancies, the more pairs of transactions can be made.
However, in addition to the above advantages, pair trading also has shortcomings, which traders also need to know:
Double commission. When using this strategy, fees and charges levied at the auction are doubled. Since there are two trading instruments involved in the pair transaction, you will have to pay two commissions for the commission. This fact must necessarily be taken into account when historical testing the strategy and calculating the potential profit.
The difficulty of matching pairs. To identify really correlated pairs, it is necessary to do serious research work with the help of an appropriate mathematical apparatus, which may not be for ordinary traders.
Pair trading can bring good profits to traders who can apply mathematical tools to match pairs, such as correlations, cointegration, regression, etc. For more information on paire trading, see this article. On the site https://megatrader.org you can also find special online services that help to select promising pairs for trading.