What is pairs trading and how does it add value? Jun Bei Liu

Pairs trading is based on the principle of statistical arbitrage, where two assets—historically correlated—move in tandem. This trading strategy is based on the idea that some assets tend to move together over time due to fundamental or market-related factors. However, short-term price fluctuations can create temporary imbalances between them. When this happens, traders use pair trading to take advantage of these price differences, assuming that the two assets will eventually return to their usual relationship. It is the responsibility of the trader to manage the position according not only to the predetermined buy and sell rules, but also to the changing market environment. The trader must be cognizant of the unexpected news releases affecting either of the instruments in a trade and be prepared to adjust their thinking accordingly.

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These are all FTSE 100 stocks, paired with peer companies, and all display at least some level of correlation. We can see, though, that the correlation for some pairs is stronger than others. The aim would be to exit the positions if and when the price relationship returns to a more normal value. It includes selecting a trading universe, constructing and testing a model, if one is to be used, and creating general buy and sell guidelines. An individual trader’s resources and expected trade duration will affect each of these factors, but the structure is functionally the same in all cases.

Because both positions are placed simultaneously, market-wide price movements have less impact on the overall trade. Instead, profits come from the price gap returning to normal rather than the market moving in a specific direction. One way we can keep tabs on whether the current price relationship is normal or abnormal by historical standards is to look at the price ratio between the two instruments over an extended time period.

Close the trade

Like any other trading strategy, pairs trading carries risks, especially if the correlation between the two assets weakens or the spread does not converge as expected. Proper risk management techniques are essential to mitigate these risks and ensure long-term success. Pairs trading enhances an Alpha Extension strategy by adding a layer of precision and control. It allows managers to isolate stock-specific opportunities while neutralising broader market and factor risks.

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The classic approach to pairs trading involves taking two highly correlated assets, as described earlier, and betting on their price convergence.
Unexpected news, earnings reports, interest rate changes, or geopolitical events can impact the assets in a pair differently, causing losses even if the original correlation was strong.
The trade could be immediately closed with a view that the additional return does not warrant the risk or the opportunity cost.
However, correlations can break down due to fundamental shifts, economic events, or industry changes, making the trade invalid.

Pairs trading began in the mid-1980s with technical analysts at Morgan Stanley, a global investment bank. The pairs trade strategy uses statistical and technical analysis to seek out potential market-neutral profits. Statistical arbitrage is a quantitative trading strategy that relies on statistical and mathematical models to identify short-term mispricings across multiple assets. Unlike pairs trading, which focuses on just two assets, statistical arbitrage typically involves a basket of securities and is often implemented through algorithmic and high-frequency trading (HFT).

What Is Pairs Trading? Strategy, Benefits, and Risks

Traders use various statistical methods to determine the best times to enter and exit a pairs trade. One common approach is to monitor the spread (the difference in price) between the two assets. When the spread widens beyond a certain threshold, it signals an opportunity to enter the trade, with the expectation that the spread will narrow again.

The most common approach is based on mean reversion, which assumes that prices will return to their normal relationship after diverging. When the gap between them closes, the trader can exit both positions with a profit. You are still exposed to other risks, such as counterparty risk, systemic risk, and that your strategy fails.

Since one position is long and the other is short, profits depend on the relative performance of the two assets rather than the market’s direction. While this would seem to be the most straightforward step in the investment process, there are a few subtleties. Generally speaking, the short side of a trade should be executed and filled before the long order is placed. In addition to the option of manually entering trades, there are some trading programs designed to handle pairs execution. These programs are designed to simultaneously work each side for the trader, particularly for larger orders, in an attempt to hit a pre-specified price ratio.

The longer we can see the correlation has persisted, the stronger our confidence might be in the relationship. If we dig further back into the data, we find that the correlation between their share prices over five years, from January 2018 to January 2023, is even stronger at 0.91. For the purposes of this example, we will use the correlation coefficient as calculated by spreadsheets such as Microsoft Excel and Google Sheets — mainly because it is relatively simple. Note there are many ways to calculate the relationship between two data sets and more complicated measures may work better in practice. After a selection process has been defined, a trader must use that process to generate a list of candidate trades.

Instead of trading a single currency pair directionally, traders go long on one pair and short on another to profit from their relative price movements. When a pairs trade goes as planned, the investor profits and can reduce potential losses. Profits are generated when the underperforming security regains value, and the outperforming security’s price deflates.

This high degree of correlation, suggesting that one stock will always (eventually) catch up with the other, is at the heart of a strategy called pairs trading. One way to implement this is using an Alpha Extension strategy, also known as a long/short extension. This approach is designed to amplify active returns by combining a traditional long-only portfolio with a short-selling overlay. For example, if stock A and stock B usually move together, but stock A suddenly spikes while stock B remains stable, traders assume stock A is overbought and stock B is undervalued. They will short stock A and go long on stock B, expecting the price gap to close.

Likewise, they must be mindful of the pair’s price action and constantly adjust the risk/return profile of the trade.
This approach typically requires access to real-time data and high-frequency trading strategies to capitalize on small price discrepancies.
The area between the highway and the service road can be thought of as the spread—the measured distance between the 2 objects traveling together.
To create a successful pairs trade, traders must first identify two assets that are highly correlated, meaning their prices tend to move in the same direction over time.
As an investor, I’m always looking for ways to generate stronger returns without taking on unnecessary risk.
If the securities return to their historical correlation, a profit is made from the convergence of the prices.

Whether you’re a novice trader or an experienced professional, understanding the nuances of pairs trading and applying the right strategies can enhance your trading portfolio. As with any trading strategy, thorough research, continuous learning, and adaptation to changing market conditions are key to achieving long-term success in pairs trading. Diversifying pairs trades across different asset classes or sectors can reduce the overall risk. By holding multiple pairs trades with varying correlations, traders can ensure that their portfolio is not overly exposed to any single asset or market condition. The strategy was popularized in the 1980s by quantitative hedge funds, and its ability to remain market-neutral while profiting from price movements of individual assets made it an attractive choice for many professional traders. Today, pairs trading is applied across various asset classes, including equities, forex, commodities, and more.

As an investor, I’m always looking for ways to generate stronger returns without taking on unnecessary risk. Markets don’t move in straight lines, and opportunities exist on both sides – in the companies that surprise on the upside and those that fall short Roboforex Review of expectations. If one leg of the trade executes but the other experiences slippage or liquidity issues, the trader could face an unbalanced position and unintended exposure. Traders monitor the spread between the two pairs, using indicators like the correlation coefficient, Z-score, and Bollinger Bands to identify trading signals.

Antonio Di Giacomo studied at the Bessières School of Accounting in Paris, France, as well as at the Instituto Tecnológico Autónomo de México (ITAM). He has experience in technical analysis of financial markets, focusing on price action and fundamental analysis. After many years in the financial markets, he now prefers to share his knowledge with future traders and explain this excellent business to them.

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At its heart, it is focused on adding value through relative performance rather than absolute performance by attempting to reduce (often cancel out), shared factor risk. It involves identifying two historically correlated stocks – often within the same sector – and taking opposing positions when their outlook and prices are expected to diverge. The goal is to profit from the relative movement between the two, assuming the spread will eventually revert to its historical mean. Pairs trading is also widely used in the forex market, where traders take advantage of price differences between two highly correlated currency pairs.