Pairs Trading 

Welcome to our guide to Pairs Trading – one of the best market-neutral trading strategies. Initially developed in the mid-1980s by Morgan Stanley quantitative analyst Nunzio Tartaglia, it once was a secretive trading strategy that gave institutional traders and hedge funds a competitive edge. Thanks to the advent of high-speed computing and online trading platforms, which made sophisticated, real-time data analysis accessible to individual traders, this once-niche tactic has been brought to the mainstream and has since become a cornerstone in modern Trading Strategies. While attractive due to the potential for profiting in any market condition and its risk-minimizing nature, this cornerstone of modern trading requires an in-depth understanding. So, buckle up and prepare to dive deep into this fascinating world of Pairs Trading!

So, buckle up and prepare to dive deep into this fascinating world of Pairs Trading!

What is Pairs Trading ?

To make the plunge into the depths of Pairs Trading, we must first understand just what Pairs Trading is. So, what is it exactly?

Pretty much the trading world's way of saying "birds of a feather flock together"! Pair Trading differs from other trading strategies that are laser-focused on how one single security performs. Instead, with this tactic, you're focusing on the price difference between two connected assets and work under the idea that two closely related securities will move together over time when they share a commonality.

How does Pairs Trading work? Pair traders will pinpoint a pair of related securities. Then, based on how the prices of these two linked financial assets have historically interacted, the trader will step in. When one asset scores higher than its partner, a Pairs Trader will typically buy into the weaker one and sell the stronger one, holding out for their prices to sync up. As the prices eventually reconverge and the value of the underperforming asset increases, a Pairs Trader will sell the asset with a rising value and profit.

Pair Trading Advantages

By predicting the convergence of divergent securities and profiting from it, Pairs Traders can function independently of overall market trends, making Pairs Trading a market neutral strategy. This is precisely where the appeal of this strategy lies, as market conditions or direction, be it bear or bull, are not a constraint. In fact the opposite is true: Pairs Trading thrives on volatility in the individual securities' price disparities!

Unlike traditional investing strategies that rely heavily on market stability for growth, Pairs Trading simply focuses on the improvement of one security and the hope that this will translate into an equivalent depreciation in the other. This negates the overall impact of market movements.

As the long position trading Strategy and short position trading Strategy offset any potential loss brought on by overall market trends, Pairs Trading assumes very little market risk.

Pair Trading Disadvantages

While the market neutrality of Pairs Trading is a huge advantage, it's critical to understand that the strategy itself is not entirely foolproof - primarily as pairs fall in and out of favor and past correlation might not persist. Although the idea of Pairs Trading is predicated on high asset correlation, this relationship isn't always consistent in the long run.

A classic example is the well-known pairing of Coke and Pepsi. Despite being a textbook duo often referred to in trading courses, a Pairs trading strategy with these two has suffered losses for several years. It's essential to remember that past performance doesn't assure future returns. Regardless of correlations established over time, predicting future asset prices is uncertain. Although historical prices can provide insights, they don't guarantee future results.

As a result, traders are always on the look-out for new pairs, while dropping those which are not profitable anymore. However, figuring out when to stop trading a pair or deciding if it's reliable enough to be added to your trading rotation isn't as simple as looking over stocks - it requires a statistical, Technical Analysis of the two securities’ correlation.

How do I calculate correlation?

Establishing a trading pair’s correlation is crucial in successful Pairs Trading. This is typically determined using statistical methods, most commonly the Pearson correlation coefficient - a measure of the linear correlation between two variables. You crunch the historical price data of the two securities, feed this data into the correlation equation, and the magic happens! The output ranges from -1 to +1. A positive correlation near +1 indicates the pair usually moves in the same direction, while a negative correlation near -1 means they typically move in opposite directions.

Pairs Trading example

Imagine you're keeping an eye on two technology giants, Microsoft (MSFT) and Apple (AAPL). Historically, these two companies have maintained a consistent ratio in their prices and tend to move together because they operate in the same industry - a classic indication for a Pairs Trade. However, recently, you notice that although Apple has been on a roll for a while with its price surging consistently over a period of time, Microsoft, though not doing poorly, hasn't seen the same sharp rise and has stayed relatively flat.

This phenomenon creates the perfect opportunity for a Pairs Trade. Observing their correlation, you correctly surmise that Apple has become overpriced relative to Microsoft, or "dislocated" as known in trading terms. So, you decide to go short on Apple (betting its price will fall) and long on Microsoft (expecting its price to rise) - assuming the price ratio will revert to its average price (mean) and aiming to capitalize on this anticipated convergence of the stock prices.

As weeks go by, just as you predicted, Apple slows its bullish run, and Microsoft starts catching up. Well done: you've just successfully executed a 'Pairs Trading' strategy!

This is a classic example of taking advantage of market 'inefficiency' by relying solely on the statistical correlation between the Pair in any market.

Trading Pairs on Crypto

Pairs Trading in the Crypto market does not differ much from other markets, as it still involves buying and selling two correlated cryptocurrencies: e.g., Bitcoin (BTC) and Ethereum (ETH). However, the correlation between cryptocurrencies behaves differently than it does for stock or forex pairs.

While the correlation in stock pairs is typically driven by fundamental factors like company performance and economic trends, in cryptocurrency, the correlation between two crypto coins can vary significantly because it's often driven by investor speculation and crypto market sentiment, which can shift abruptly and unexpectedly.

For instance, a sudden news item or social media trend may swiftly alter the perceived value of a cryptocurrency and break previously reliable crypto correlations, such as the one between Bitcoin and Ethereum. Imagine you've gone long on Bitcoin and short on Ethereum based on their historical correlation. However, a sudden tweet from a prominent tech figure like Elon Musk or news about a significant technological advancement in Ethereum's network hits the internet. This could fuel a flurry of purchases of the Ethereum cryptocurrency, inflating its value almost instantly – while you were betting on an ETH price decrease. Simultaneously, the American government may announce stricter regulations for cryptocurrencies, leading Bitcoin to stray from the expected appreciation and a significant divergence within your pair - ultimately, threatening your perfectly planned Pairs Trade. This increased volatility makes Pairs Trading in crypto much more volatile than traditional fiat currencies.

How to trade Crypto pairs 

Though the crypto market’s volatility presents challenges, a well-prepared trader can still use Pairs Trading in the crypto market to their advantage. The key lies in understanding the dynamics that drive these sharp price movements by regularly monitoring crypto market news, being aware of shifts in investor sentiment, and staying updated with developments in the crypto industry so you can predict short-term crypto divergence and convergence patterns as best as you can.

Stock Pair Trading

Pairs Trading in the stock market is uniquely distinguished from Pairs Trading in other markets primarily due to the distinct nature of stocks. The most significant difference lies within the correlation factor. In the stock market, Pairs Trading relies heavily on the strong correlation between two stocks - often within the same sector. Pair traders capitalize on temporary price disparities between these two closely related stocks, expecting any deviation from their average correlation to be short-lived and their prices to reconverge. This emphasis on correlation differentiates stock Pairs Trading from similar strategies in the forex or commodities market, where supply and demand dynamics or macroeconomic factors may hold more sway.

Furthermore, the stock market’s broad availability of company information facilitates a comprehensive analysis for pairs selection, creating a more informed risk mitigation strategy. Now, while it remains an advanced trading strategy requiring sophisticated market comprehension and careful selection, the flexible nature of Pairs Trading, alongside the advent of automated trading systems, has rendered it more accessible for diverse trader profiles seeking portfolio diversification and risk-adjusted returns.

Pair Currency Pairs

Due to their high liquidity and vast availability of data, Currency Pairs are one of the most popular choices for Pairs Traders as they form the backbone of the vast forex market. A currency pair basically consists of two different types of currencies, where one currency is being bought and the other sold. These pairs are represented as a ratio that showcases the value of one currency relative to the other.

An example of a major currency pair is the EUR/USD, where the Euro is the base currency (the first currency listed), and the U.S. Dollar is the quote currency (the second listed currency). The base currency’s value is always 1 when compared to the second currency, while the quote currency’s value tells you how much it costs in relation to the base currency. This means that the EUR/USD Currency Pair ratio represents the amount of USD needed to buy one Euro.

Best trading currency pairs

When it comes to trading currency pairs, a few stand out as popular choices among traders. As already mentioned, the EUR/USD pair is often a favourite due to its high liquidity and low spread – but more importantly, its trends are somewhat predictable. This is thanks to its status as the most traded currency pair globally and its influence by key economic data.

Another top pick is the GBP/USD pair, often referred to as 'cable' – a nickname for the Pair dating back to the 19th century when GBP and USD transactions were executed through the undersea transatlantic telegraph cable. While the Cable tends to have a higher spread than EUR/USD, it can offer high volatility, creating potential opportunities for profit.

Lastly, pairs like USD/JPY and AUD/USD also remain favourites due to their strong market trends and clear technical patterns.