Pairs trading is a market neutral trading strategy a lot of hedge funds and prop traders take advantage of. Throughout this guide, you’ll learn the fundamentals of pair trading strategy and how to hedge your trades from unforeseen market movements.
Pairs trading relies on a mathematical concept known as cointegration. For the purpose of this article, we’re not going to worry too much about the pair trading formula and the pairs trading quantitative methods and analysis.
When it comes to trading, managing risk is critical. The market is full of expected and unexpected risk factors. These risks can make it harder for you to profit from trades and minimize risks at the same time.
No market on Wall Street is entirely risk-free. This means we need some strategies to help mitigate the risk. In this regard, to help minimize risk of an unexpected event, professional traders can use the pair trading strategy to protect a particular trading idea.
Pairs Trading – How it Works?
Pairs trading is a strategy used to trade the differentials between two markets or assets. With this strategy, you shouldn't focus on what one individual currency or stock does. Instead, focus on how the relationship between those two work.
Pairs trading is essentially taking a long position in one asset. At the same time, you take an equal-sized short position in another asset. The two assets need to be highly correlated. They can be anything from two stocks, currencies, commodities, options or exchange-traded funds (ETFs).
Note*: You first want to trade two things that are ultimately reasonable correlated.
The best forex pairs to trade with this market neutral strategy are the one with the highest correlation.
Overall, the two trades matched should give us a neutral or risk-free position that allows traders to make a profit in the market.
Why Does the Pair Trading Strategy Work?
Pairs Trading Example
Let’s take a pairs trading example and assume our trader Joe want to buy Twitter. Our trader has identified a bullish trend or a pattern that suggests the Twitter stock price is going to go up. In order to mitigate the risk of being wrong, Joe decides to pair his trade with another sector-related stock.
Among the best pair trading stocks, Joe chooses to match his long Twitter position with an equal-size short Facebook position.
Depending on the difference between the gain and the loss of each trade, Joe can either lose or make money. With the pair trading strategy, when you lose you only lose small, but the profit potential is so much greater.
If both Twitter and Facebook stocks go up, Joe pockets the difference between the profits made on the long position and the loss in the short position. Assuming that the relative performance of Twitter stock is better than the relative performance of the Facebook stock, Joe is profitable.
However, no matter of where the general market goes one of the positions will always show a profit while the other one will show you a loss. In very rare circumstances you can end up with two winning or to losing positions.
Let’s now outline the rules of a very simple pair trading strategy that can help us hedge the risk
Pair Trading Strategy Rules
Before utilizing the pair trading strategy we first need to make sure that the instruments we’re going to trade are correlated. What we want to see is a positive correlation were both instruments move in tandem.
Our pairs trading strategy model uses a unique approach when trying to pair trading stocks.
What we look for is correlated stocks that have short periods when they diverge from one another. If these stocks have strong correlation, then eventually they will revert back from trading in tandem.
From these price irregularities we can actually make a profit.
Here is how you can spot a trade with the pairs trading strategy.
Step #1: Identify Two Correlated Stocks that have a strong positive correlation
Since this is a neutral trading strategy, the market direction doesn’t matter that much. As long as we have picked two stocks that have a strong correlation and they stopped moving in tandem, then we can make a profit once the two stocks get in sync later in time.
In the chart below we can see that General Motors and Tesla often move in tandem. When the correlation stops, then we’re presented with a trading opportunity to short-sell General Motors when it’s outperforming and go long Tesla when it’s underperforming.
In the chart below, we have identified an instance were Tesla stock price rallied sharply in value relative to GM stock price.
What is more difficult is when to time your trades, how to manage risk and when to clear the profits.
For this we’re going to reveal you an important trading secret.
Step #2: Divide the Tesla stock price by GM stock price
Tradingview allows you to plot the ratio of one stock against another stock. All you have to do is to divide the share price of Tesla by the share price of GM. Simply put “TSLA/GM” in the ticker symbol box and you will see the ratio between the two stocks plotted on the chart.
The ratio shows that the share price of TSLA is 8 times more expensive than the share price of GM.
To have a better reading of these ratios, we need to use one special trading indicator.
Step #3: Apply the BB indicator using 200 periods and 2 standard deviation
We use the Bollinger Bands indicator to spot the times when the correlation between the two stocks has moved too far from the norm, which will result in a trading opportunity.
As a general rule when the stock ratio reaches the upper BB or 2 standard deviations, you can sell Tesla and Buy GM. However, when the stock ratio touches the lower BB or 2 standard deviations, you should buy Tesla and sell GM.
The next section will show you how to manage your risk and the trade.
Step #4: Take the trade once the ratio reaches 2 standard deviation.
Once we make sure the stock price doesn’t move in tandem anymore, then a trade can be taken right away when the stock ratio touches the upper Bollinger Bands.
A safer approach is to wait for the ratio to start moving back towards normal. This way you can avoid holding a losing trade for too long. Additionally, you can also use the recent swing highs and lows that will develop as a place to hide your protective stop loss.
Have a look at how the trade looks on the price chart:
With the first approach you would have short-sell TSLA on August 2 at $350 a share. And, bought GM at $37 a share.
With the more conservative approach, if you waited for the ratio to turn back inside the BB you would have short-sell Tesla on August 16 at $335.45. And, bought GM at $36.29.
The difference between the two approaches is that the second entry strategy will eat up from your profits, but it will give you a safer location to hide your SL.
Once the price discrepancy between the two stocks vanishes, meaning the ratio returns back to normal aka the 200-day moving average, we want to cash in our positions.
On August 20 the ratio signals that the two stocks are now starting to trade in tandem again. On this date, one share of Tesla is worth $288.20 while one share of GM is worth $36.36. Because the price correlation between the two stocks has been reestablished the reason behind our trade has gone so we want to close our positions.
Let’s assume that we have put at work $10,000 for each of the two stocks. In this case scenario, we would have bought 28 share of TSLA ($10,000/$350) and sell 270 shares of GM ($10,000/$37).
Let’s do the math and see how much money we’ve lost or made after we closed the positions on August 20:
Long Tesla Trade: $350 - $288.20 = $61.8 *28 shares = $1730.4 Profit
Short GM Trade: $37 - $36.36 = $0.64 * 270 shares = $172.8 Loss
Net Profit/Loss: $1730.4 – 172.8 = $1, 5557.6
Not all best pair trading stocks will work out this well. Sometime we can get a loss on both trades or other times even see profits on both the long and the short trade.
Conclusion – Best Pair Trading Stocks
The pair trading strategy enables traders to profit from virtually any market conditions: bullish trends, bearish trends and even range trading markets. The essential part to a successful pair trading is relative performance. To have peace of mind, professional traders only target the relative performance of their first trade compared the performance of its matched trade.
The most critical part of any pair trade is how to identify the best forex pairs to trade. If executed properly, the market neutral pairs trading strategy can take away a lot of the irritation out of trading.
The advantage of using the best pair trading stocks is that you have a lot of flexibility. You also don’t have to guess the general market direction.
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