Trading in the stock market is characterized by the use of various trading strategies to maximize profits and minimize risk. One of such strategies used by traders in the market is pairs trading. Pairs trading strategy involves matching a short position with a long position in two different stocks having a high correlation.
Pairs trading is not commonly used by Indian traders but is a very common strategy in the international markets. The origin of pairs trading strategy dates back to early 1980s. The strategy was initially developed by stock market technical analysts and researchers which were employees of the renowned investment banking and financial company – Morgan Stanley. Implementing pairs trading strategy requires usage of technical and statistical analysis for extracting market-neutral profits.
Today, we will take a detailed look at pairs trading strategy and also learn about the advantages and disadvantages of pairs trading to find out whether this strategy is suitable for you or not.
Table of Content
Defining Pairs Trading Concepts
What is Pairs Trading?
The basic of pairs trading lies in the correlation of securities. For pairs trading, it is necessary that the two securities must have a positively high correlation. This high positive correlation is the prime driving force behind the profits of pairs trading strategy.
Pairs trading is a market-neutral strategy and requires you to have two positions – long and short in two different high correlation securities. These two positions are the basic for developing a hedging strategy which aims to extract profits from a negative or positive trend in the market.
The best time to implement a pairs trading strategy is when there is a correlation discrepancy in the market. When the trade eventually starts to deviate, you can expect profits from the long position in the underperforming security and short selling the outperforming security. However, in a case when the securities return to their historical correlation, you can expect profits from the convergence of the prices.
Example of Pairs Trading
For better understanding of pairs trading, let us take an example. Suppose there are two stocks X and Y. These stocks are having a high positive correlation of 0.95. Now, both these stocks start deviating from their historical correlation within a short term, with a correlation of 0.35.
Now at this point, traders will step in and take a dollar matched short position on the outperforming stock Y and a long position on the underperforming stock X. After some time, these stocks converge and return back to their correlation of 0.95. At this point the trader will book profits from the long position and exit from the short position.
Advantages of Pairs Trading
The first and foremost advantage of implementing pairs trading strategy is that it helps to maximize your profits and also helps in mitigating the potential risk at the same time. As an investor, this is what everyone expects in the market – maximum profits with minimum risk. With a pairs trading strategy, you will generate profit when the underperforming security starts regaining its value and there is a deflation in the price of the outperforming security. The net profits from both these positions, minus any potential losses will be your total profit generated in pairs trading.
Disadvantages of Pairs Trading
Like every other market trading strategy, pairs trading also comes with its own set of cons. The biggest con of pairs trading is that it relies on high statistical correlation between the securities. It can be very challenging for you as a trader to identify such correlations. Also, historical trends may be mostly accurate, but they do not guarantee an indication of future trends. Pairs traders usually look for a correlation of 0.80 which can also lower down the chances of expected profits.
Conclusion
Pairs trading relies on historical data and requires high usage of technical and statistical analysis. If you do not have detailed knowledge about market research and analysis it is recommended to stay away from pairs trading. However, if you still want to implement pairs trading strategy it is better to take the help from a certified investment advisor who can help you by research and analyzing the market trends to help you develop a successful pairs trading strategy.
Happy Investing!
