Pair Trading Explained?
Pair trading refers to a kind of trading strategy in which there is a matching short position with a long position. This happens in 2 stocks that have a high correlation. The aforementioned is usually due to the historical correlation of two securities. The high positive correlation acts like the primary driver behind the profits of the strategy. You can deploy a pair trade strategy the best way when you identify a correlation discrepancy. You may rely on the historical notion that the securities would maintain a certain correlation, and deploy the pair trade when the correlation falters.
What Assets Can You Trade in Pairs?
Stocks: Traders can use fundamental or technical analysis for assembling a pairs trading idea. These can include anything from P/E ratio, earnings, revenues to simple moving averages. Anything that can explain or argue the divergence of two stocks is helpful. Here is an example of technical in nature.
First, you need to find two highly correlated stocks for designing a pair trade. Generally, it means that the businesses are within the same industry or sub-sector, but there are exceptions. First example: two companies have similar fundamentals, but due to speculative downside or upside pressure in one stock, it becomes overvalued or undervalued. The second case is when fundamentals in two companies are significantly different: company A has an approach to expand faster, to improve their product, and has more revenue growth – it affects the stock price and the fair value of the company. Company B is not performing that well or can even be unprofitable. However, the stock can grow as well as company A’s if it is performing in the same trending industry. It creates an opportunity for pair trading: you can sell the stock with good fundamentals and sell the on with weak numbers.
Futures: Apart from stocks, the pairs trading strategy works with currencies, commodities, and futures. In the futures market, mini contracts or smaller sized contracts representing a fraction of the value of the full-size position allow smaller investors to trade.
Pair trade in futures can involve an arbitrage between the futures contract and the cash position of a provided index. When the futures contract goes ahead of the cash position, traders may try to short the future and go long in the index tracking stock to earn a profit, while expecting them to come together at one point. The moves between a commodity or index and its futures contract are often so tight that it leaves profits only for the quickest traders who use computers and automated trading software to execute enormous positions in the blink of an eye automatically.
Options: traders use call and put options for hedging and exploiting volatility. A call is a commitment by the writer to buy an asset for a given price in the future. On the contrary, a put is a commitment by the writer to sell an asset for a given price in the future. Pair trade in the options market may involve buying a call for security outperforming its pair, which is another security with high correlation. It can also involve matching the position by buying a put for under-performing security. When the two underlying positions again revert to their mean, the options become worthless and allow the trader to pocket the proceeds from one or both positions.
Is Forex Pair Trading Possible?
Pair trading strategy identifies two assets having a high amount of historical positive price correlation. It also identifies when one asset is over-performing and the other is underperforming by more than a specific standard deviation. In the same cash amounts, the underperformer goes long and the over-performer goes short. If the price of the pair begins to converge, and the divergence reduces to a normal historical level, the trade exits at a profit.
On the other hand, a stop loss applies, in case, prices move in the opposite direction. Although there are lots of interests in such market neutral strategies, you should not assume them to be risk-free. Another potential drawback for the retail trader is that they usually require large capital for operating successfully. However, you can still apply the strategy in forex. For that, you have to identify currencies of economies with high positive price correlations such as the Australian and New Zealand Dollars, or the Euro and Swiss Franc.
How to Perform Pair Trading In Forex
There are various ways to execute pair trading in forex. If you are trading cross currency pairs, it is easy to buy and sell a currency pair or use the options market. In futures pair trading, however, you will have to buy one asset like gold and simultaneously short another asset like silver.
The execution of a cross-currency pair transaction is straightforward, but the initial amount you must trade while executing a pair of assets can be tricky. The objective is executing the identical amount buy and sell positions. For instance, the calculation of a pair trade of gold and silver would be like this –
You can start by determining the notion quantity you want to trade. For instance, if you want to transact a trade of $5,000 when gold prices are at $1,250 per ounce and silver prices are at $17 per ounce, you may divide $5,000 by $1,250 and get 4 ounces of gold or divide it by $17 to get 294 ounces of silver. It assumes a cash trade, and the process is similar while executing an ETF trade or a futures trade. You cannot find a contract of 4 ounces of gold in many cases, but this calculation shows the ratio of gold to silver according to the notional quantity that you may trade.
Another way of a pair trade transaction is the use of options. If your strategy can evoke pair trading with options on a currency pair and you think that it can move higher, you can buy a call option. It would be the right but not the obligation to buy a certain quantity on or before a specific date. Alternatively, if you are selling a currency pair, you can buy a put option.
When you buy a forex option, you pay a premium to the option seller for the right to purchase or sell a currency pair. The call option expires worthless in case the exchange rate is much below the strike price at expiration. In the same way, the put option expires worthless if the exchange rate is above the strike pose.
The Bottom Line
The broad market is filled with ups and downs that eliminate weak players, and it may even confound the smartest prognosticators. Fortunately, traders and investors can earn profits in all market conditions by using market-neutral strategies like the pairs trade. The benefit of pair trading is its simplicity. With the right planning, pair trading is the key to your success in the forex market.