Pair trading is a market-neutral strategy that is based on finding price correlations between a pair of financial assets.
This type of trading allows parallel trading of two or more assets that are traded in opposition to each other. The strategy can be applied to stocks, commodities, currencies, and cryptocurrency.
This methodology was developed in the 1980s by a group of technical analysts at Morgan Stanley. It allows a trader to profit in all types of markets, while still being a market-neutral strategy. The strategy brought the creators $50 million initially, but then a significant loss during the 1987 “Black Monday” global crisis, because many companies' stocks collapsed catastrophically in price.
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Explanations and definitions of terms.
Basic Strategy Principles
Pair trading is based on related assets that have high correlation coefficients, which are statistical relationships between two or more random variables.
The correlation is often positive such as between:
- GBP/USD and EUR/USD
- S&P 500 and Dow Jones
- Bitcoin and Ethereum
- Oil prices and oil company stocks
- Shares of companies from the same sector like Coca-Cola and Pepsi
However, it may be negative with assets trading in different directions such as:
At these moments, there is a divergence detected between the strongly correlated assets. For example, the price of oil may fall, while an oil company stock grows. The basic logic of the strategy is that over time, this deviation should level out and the assets will once again begin to move synchronously.
In order to get a return on the paired trading strategy, it is necessary to do the following:
- Find correlating assets
- Detect divergence of one asset from another
- Open trades in opposite directions. Use Forex mode on the Olymp Trade platform to trade Up one and Down the other.
- Wait for assets to converge and close both trades.
Using the Strategy to Trade Pairs
Let's look at a pairs trading strategy example. Two stocks from one sector and one type of activity are chosen as assets: Visa and MasterCard. They have a very high positive correlation.
However, in mid-November 2021, MasterCard began to rise vigorously, while Visa remained at the same level. Let’s open two trades, a Down trade on MasterCard and an Up trade on the 2nd asset. The stock of Mastercard started falling and Visa's Up trade went to zero. While the first one was profitable, it is best to close both trades and observe how the shares continue to move in sync thereafter.
Risks of this Trading Strategy
The main risk is that the correlation between assets may not recover. For example, the strategy showed great results between 2002 and 2008 for General Motors and Ford. However, General Motors went bankrupt in 2009 and if we had traded it Up, we would have had a serious loss.
Therefore, for this strategy, traders should choose the assets carefully and use it in times where there isn’t significant financial turmoil. In other cases, traders will profit or close the trades with almost zero result.
We recommend that you pay attention to fundamental analysis in order to make correct decisions regarding the correlation of certain assets. Read and watch economic news and analyze the reports of major companies. Insights from Olymp Trade analysts can save you a lot of time. Also, keep an eye out for new signals on the Olymp Trade platform. With their help, your trading can become more profitable.Try It on a Demo
Risk warning: The contents of this article do not constitute investment advice, and you bear sole responsibility for your trading activity and/or trading results.
A market-neutral strategy is a type of investment strategy that seeks to profit from both increasing and decreasing prices on one or more markets/asssets while attempting to completely avoid some specific form of market risk.