A Simple Trading Strategy: Pairs Trading
Pairs trading is a market neutral strategy, which involves undertaking a long and short position in stocks that have a high correlation.
The main idea behind Pairs Trading is to take the advantage of market inefficiencies. Here are the steps:
- Find two stocks that are consistently correlated
- Wait till one of them breaks the pattern
- Then buy the cheap one, sell the expensive one
- Wait till the trend reverses to the normal pattern
- Then close the position
Understanding Pairs Trade
Pairs trading or statistical arbitrage was first developed and put into practice by Nunzio Tartaglia, while working for Morgan Stanley in the 1980s. Tartaglia formed a group of mathematicians, physicists and computer scientists to develop automated trading systems to detect and make use of mispricings in financial markets.
Pairs trading was one of the most profitable strategies that was developed by this team. When people from the group started to leave, also knowledge of pairs trading strated to spread.
These arbitrage opportunities are often times hard to spot since the true values of securities are unknown. Pairs trading uses the relative values between stocks to find “mispricing” and successfully refrains from relying on true security values.
SEE ALSO: Derivatives 101: Overview & Types
This strategy was highly profitable when it was first developed and implemented. However, as knowledge spread, profit from pairs trading was said by some to have diminished while the risk involved shot up.
Selling overvalued securities and buying undervalued ones is the general ’rule of thumb’ in trading. If and only the true value of the security is known, then it’s possible to determine that a security is overvalued or undervalued. The true value can be very difficult to determine.
Pairs trading is about relative pricing, so that the true value of the security is not important. Relative pricing is based on the idea that securities with similar characteristics should be priced more or less the same. When prices of two similar securities are different, one security is overpriced with respect to its ’true value’ or the other one underpriced or both.
Advantages of Pairs Trade
The pairs trading helps to hedge sector and stabilize market-risk. When the market goes down, we should experience a gain on the short position and a negating loss on the long position, leaving our profit close to zero in spite of the large move.
Disadvantages of Pairs Trade
Pairs trading became less advantagous as more people involve in. Hedge funds use algorithmic trading strategies that monitor for deviations in price, automatically buying and selling to capitalize on market inefficiencies. This programs trading requires fast reaction to take advantage of tighter spreads before other people can.
Conclusion
Pairs trading can help traders to generate alpha returns. However, pairs trading also carries risks, so traders must carefully select their pairs and monitor the market and economic conditions.
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