Last Updated on September 27, 2023 by BFSLTeam BFSLTeam
To profit from market movements, it is necessary to reasonably estimate the direction in which stock prices will move in the future. However, if you are not sure of the potential trends that will prevail in the market in the near future, you need to adopt a market-neutral strategy, which may work in your favour irrespective of bullish or bearish price movements.
Pair trading is one such market-neutral strategy that could work well if you are unsure of how the market may move in the coming weeks or months. In this article, we’ll take a closer look at what pair trading is in the stock market, how it works and the important aspects of this strategy.
Table of Content
What is Pair Trading?
Pair trading is a market-neutral strategy that involves taking a long position in one stock or security and a short position in another. The two securities must have a high correlation, meaning that their prices must be related and move in specific patterns with respect to one another.
Since you have a long position and a short position, your likelihood of earning profits is typically decent, no matter which way the market moves. This is precisely why pair trading in the stock market is considered to be a statistical arbitrage or market-neutral technique.
How Does Pair Trading Work?
The fundamental idea behind pair trading is that if two stocks are highly correlated, their prices will move in similar patterns with respect to one another. And if there is a temporary deviation in this pattern, you can take advantage of this discrepancy because eventually, the prices will once again rise or fall to maintain their correlation.
Let’s discuss an example of pair trading for more clarity on this subject. Say there are two stocks — A and B — that are highly correlated because they belong to the same industry. The price of stock A rises tremendously, while the price of stock B remains neutral. So, you identify a pair trading opportunity and decide to take a long and short position in these stocks.
Here is a breakdown of how to execute this pair trade and the rationale behind it.
- The Distance or Spread
Instead of predicting which stock will do better, you look at the difference in their prices. This difference is called the ‘spread’. If the spread becomes unusually wide or narrow compared to historical data, it signals a trading opportunity.
- Betting on the Spread
If you believe the spread is too wide and will narrow (like if stock A has gone up a lot recently but stock B hasn’t), you’d buy stock B (assuming it will rise or catch up) and short-sell stock A (assuming its price will fall). If you believe the spread is too narrow and will widen, you do the opposite.
- A Balancing Act
The goal is to profit from the changing spread rather than the outright performance of the stocks. So, even if both stocks go down, you could still make a profit if the one you short-sold (or bet against) drops more than the one you bought.
How to Select Stocks for Pair Trading?
Keep the following aspects in mind when you are selecting stocks for pair trading.
- Historical Price Movements
You must analyse historical price patterns to establish a correlation between the two stocks you choose. It is not enough to look at the price movements of the past few days alone. Instead, analyse the performance of the stocks over the past 1 year, 3 years and 5 years if possible.
- High Correlation
Stock correlation ranges from —1 to +1. A negative correlation means that when the price of one stock rises, the price of the other falls. A positive correlation indicates that the prices of both stocks rise or fall simultaneously. Ideally, you should choose stocks with a correlation of 0.8 or more.
- Timing the Entry and Exit
If you observe a discrepancy in the price movements of the stocks, you can initiate the pair trade. Then, when the prices revise to attain their original correlation, you must exit the two trades and buy/sell the stocks as needed.
- Risk Management
Like all trading strategies, pair trading is not without its risks. If the spread doesn’t move as anticipated, you could lose money. So, it’s essential to have a good understanding of the stocks and use appropriate risk management techniques.
Conclusion
Now that you know the meaning of trading pairs of stocks or securities, you can employ this strategy if the market conditions are conducive to this technique. Since it involves taking two opposing positions, you must be reasonably sure that there will not be a strong uptrend or downtrend, since that would make one of the positions more worthless right from the get-go.
Additionally, since pair trading may be quite complicated for beginners, it is advisable to practise simulated pair trades before you actively use this strategy in the live market. This will help you understand the nuances of the strategy better, so you can use it to your advantage.
