Pair Trading Basics

Pair trading is a market neutral trading strategy. It involves trading on highly correlated instruments. For detailed explanation on correlation please refer to our previous post. The idea of pair trading is to wait for periods of weak correlation between the two highly correlated pairs/instruments, going long on one of the symbols and short on the second symbol. When the correlation between such instruments drops, it is considered that one of the instruments is over-performer and/or the other is an under-performer. This happens due to changes in supply/demand, reaction to various news events, large orders being placed on one of the symbols, etc. Profit can be realized in any market conditions: uptrend, downtrend or sideways.

It is expected that the two instruments will get back to their normal highly correlated state, collecting profit from the difference of price change between the two instruments. A simplified example of pair trading is trading Pepsi and Coca Cola which are correlated instruments since they share a common market. If it happens that the price of Coca Cola rises significantly while the price of Pepsi remains relatively the same, a pairs trader can go short on Coca Cola and long on Pepsi assuming that the two will eventually come back to their balance point. It is expected that either Pepsi price will follow and rise or Coca Cola will go down. In either case profit will be realized by the trader.

Pair trading is a mean reversion strategy. It is considered a lower risk strategy similar to hedging. Though, there are some key risk points to be considered:

• It’s expected that the two prices will converge to their historical balance (mean). However, that might not be always the case, or at least it may not happen as quickly as expected.
• It is possible that the difference between the traded instruments increase further and incur losses on both positions opened.
• The deviation from their balance point must be enough to cover the spread/commissions of the two orders opened.
• One of the symbols could be more volatile than the other. Trade size could be adjusted to compensate for this.

Dealing with such situations requires a careful risk management.

Usually measuring just correlation is not enough and some more complex techniques are used. Some of them will be discussed in our next posts.

References:

1. https://en.wikipedia.org/wiki/Pairs_trade