What is Pairs Trading – Working and Strategy
Pairs trading is a strategy where traders buy two highly correlated stocks. Then, they take a long position in one stock and match it with a short position in the other stock. It is also called a market-neutral strategy because you can generate returns irrespective of market movements. So, whether the market rises or falls, the pairs trading strategy will help you generate returns by utilising the correlation between two stocks.
This blog is a new investor’s easy guide to pairs trading, how it works, examples, strategies, how to implement it, benefits and limitations. Read on!
How Does Pairs Trading Work?
To trade using the pairs trading technique, you have to identify two stocks that fulfil the below-mentioned parameters:
- Belong to the same industry
- Have a high positive correlation with each other
- One stock is undervalued while the other is overvalued
After you select a pair of stocks, estimate the ratio of their prices over some days. This will give you an average range to establish the historical correlation between the price movements of both stocks.
Now, if, on any day, the price ratio exceeds or falls short of the established range, you get a trade opportunity. Using the pair trading strategy, you will enter a short position in the stock that is overvalued. At the same time, you will enter a long position on the undervalued stock.
Then, you wait for the stock prices to move back into the established ratio range or breach it. Once it does, you can close your stock positions and make a profit.
Example of Pairs Trading
Here’s an example of how pairs trading works. Let’s assume two shares, A and B, and their prices over a 7-day period:
| Trading days | Stock A | Stock B | The ratio of their prices |
| Day 1 | Rs.65.30 | Rs.32.30 | 2.02 |
| Day 2 | Rs.71 | Rs.34.2 | 2.07 |
| Day 3 | Rs.65.8 | Rs.35.42 | 1.86 |
| Day 4 | Rs.73.2 | Rs.36.8 | 1.99 |
| Day 5 | Rs.73.6 | Rs.37.2 | 1.98 |
| Day 6 | Rs.82.5 | Rs.38.1 | 2.17 |
| Day 7 | Rs.86.3 | Rs.38.7 | 2.22 |
The ratio ranges from 1.8 to 2.25.
Now, assume that the price of Stock A increases to Rs.90 while that of Stock B increases to Rs.55. The ratio becomes 1.64, which is lower than the range of 1.8 to 2.25.
You can, thus, enter a trade under the pairs trading strategy. Stock B is overvalued compared to Stock A. You will, thus, sell Stock B (say 100 shares) and buy Stock A (say 20 shares).
Now, you will have to wait for the prices to correct themselves. Suppose, after a few days, the price of Stock A falls to Rs.89 while that of Stock B falls to Rs.40. In this case, the ratio becomes 2.23. Now, you will sell Stock A and buy Stock B.
Here’s what you earn from the trade –
Stock A –
- Cost price – (Rs.90 * 20) = Rs.1800
- Selling price – (Rs.89 * 20) = Rs.1780
- Loss – Rs.20
Stock B –
- Cost price – (Rs.100 * 40) = Rs.4000
- Selling price – (Rs.100 * 55) = Rs.5500
- Profit – Rs.1500
Total profit = Rs.1480
Though the price of both the stocks fell, you managed to make a profit from the trade.
Attributes of Pair Trading
For the pairs trading technique to work, the following attributes are a must:
1. The Right Securities
The first prerequisite is the right selection of the securities. You need to choose securities in the same asset class, like stocks, and those too in the same category, like stocks of two banks or power companies.
2. Relationship Between the Securities Selected
The securities should be related to one another in such a way that a change in the price of one security is reflected similarly on the other.
3. Deviation Between the Securities
Sometimes, the correlation between the securities might deviate due to short-term market fluctuations. For instance, in two banking stocks, one stock might see a fall in price after a dull quarterly result, while the other stock might not be affected at all.
4. Deviation Time
Though the securities might deviate, the deviation is a short-term affair, and the securities align with each other again.
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Strategies of Pairs Trading
To use pairs trading to generate returns, here are the strategies that you should apply –
1. Select Similar Securities
As mentioned earlier, you will need to first select the industry whose stocks you will pair for the strategy. Once done, you can select two stocks from the same.
2. Opt for Securities with a High Positive Correlation
The correlation between stocks ranges from -1 to 1. To choose the ideal pair of stocks, you should pick a pair that has the highest positive correlation with one another. This means that the pair of stocks whose correlation to 1 is the closest will be the ideal pair.
3. Track the Correlation Daily
Once you have selected the stocks and identified their average correlation, track the figure daily to look out for deviations.
4. Bank on Any Deviation From Correlation
As soon as you find any deviation, look to enter a trade. Short-sell the overvalued stock and buy the undervalued one. Then, when the correlation reverts back to normal, reverse the trade and make a profit in the process.
How to Implement the Pairs Trading Strategy?
You have to use the attributes and the strategies of pairs trading to implement the strategy to your advantage. Thus, to implement the strategy, the steps are as follows:
- Identify two stocks
- Track their daily correlation
- In the case of any deviation, implement the pairs trading technique
- Open a trade in both the stocks and then close it when the correlation normalises
Advantages of Pairs Trading
The technique of pairs trading is quite beneficial because of the following reasons:
- Losses are minimised, and you can generate a profit through opposite positions in two different stocks. You can also reduce the risk of investing because if one stock is undervalued and one overvalued, the valuations correct themselves with time. This correction offsets one another when you hold both securities, and thus, your investment risk is minimised.
- While risks and losses are minimised, you can earn attractive returns on your trade irrespective of how the market performs.
- You can hedge against market volatility as you sell overvalued securities and invest in undervalued ones.
Disadvantages Pairs Trading
While beneficial, there are some limitations of pairs trading. These include the following:
- The strategy relies heavily on the historical correlation between two securities. Moreover, for the strategy to work, you need a high positive correlation, usually 0.80 or above, which is challenging to find.
- Past performance might not hold true in the future. As such, using historical data might not give you the desired results.
- The strategy works on the assumption that the correlation between two securities is always maintained. This might not hold true in all cases. For instance, in two banking stocks, if one bank is consistently making losses and looking to liquidate, the correlation will get skewed.
Final Word
The pairs trading strategy can be employed to trade risky markets and make profits. It requires you to estimate the correlation between one overvalued and undervalued stock and monitor their daily correlation. It also requires regular tracking so that you can benefit from a change in the deviation of correlation. Understand how the strategy works and use it to implement a market-neutral strategy and earn returns irrespective of market movements.
FAQs
Ans: The basis of pairs trading is that the correlation between securities will always be maintained. Even if there’s a deviation, the securities will revert to their correlated prices with time.
Ans: You can calculate the correlation yourself. Alternatively, correlation data is available on many online portals that assist in trading.
Ans: The main risk of pairs trading is the assumption that the correlation between securities will always hold. This assumption might not prove true every time.
Ans: Yes, you can use the pairs trading strategy for any security or asset whose pairs exhibit a positive and high correlation. For instance, besides stocks, the strategy can be used for forex, crypto, futures, etc.
Ans: For the deviation to correct itself (so that the strategy can work), you might need to hold your position beyond the intraday session. So, pairs trading might involve a longer trading period than intraday trade.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
