How to Create a Pair Trading Strategy
Pair trading is a method of trading which involves taking two positions in two separate financial instruments in order to reduce your market risk. If you are interested in learning more about what it is, how to create your own pair trading strategy and more, read on!
Table of Contents
What Is Pair Trading?
Pair trading is a method of hedging risk in the financial markets. A pairs trade involves opening two positions, one long and one short, on two different instruments which have a high positive correlation.
A positive correlation exists between two assets when their prices tend to follow the same trajectory. If the price of one asset goes up, the other does too and by roughly the same proportion. The same is true when there is a fall in price.
By having one "long" and one "short" position you are now protected, or hedged, from any market wide movements. If both instruments fell by roughly the same amount, the loss from your long would be roughly covered by the gain from your short.
For this reason a pair trading strategy can be described as a "market neutral" strategy which allows a trader to potentially profit from any market condition.
A pair trading strategy works based on the assumption that, if two financial instruments have had positive correlation in the past, they will continue to do so in the future.
Pair trading is best employed when a divergence in the price of two positively correlated instruments is identified, with the assumption being that the historic correlation will lead to the prices moving back towards each other after the divergence. This is most effectively explained with an example.
An Example of Stock Pairs Trading
Let's say that we establish a very high positive correlation between the stocks of Company A and Company B.
Despite the historically high correlation, Company A's share price begins to increase, whilst Company B's share price decreases.
The logic behind a pair trading strategy is that, eventually, the price of the two stocks will move back towards each other due to their high correlation.
In this scenario, therefore, a short trade would be placed on the stock of Company A and a long trade on Company B's shares in the hope of profiting on one, or maybe both, of the price movements when the assets move back towards one another.
How to Create a Stock Pair Trading Strategy
Identify a Pair
The first step towards creating a stock pair trading strategy is to identify two financial instruments which have a high positive correlation. But how can you do that?
It is possible to look at two different instruments and come to the conclusion that, due to a commonality, there may be correlation between the two. For example, stocks of companies which operate in the same industry, such as Coca Cola and Pepsi or Dominos and Papa Johns, might be expected to have a positive correlation.
Looking for logic behind correlation is an important step for some people. This is because it is entirely possible that two completely different things have a strong correlation by pure coincidence. This might not matter to some people, but to others this would be a reason to ignore these pairs when creating a pair trading strategy.
Demonstrate Correlation Between the Pair
For traders who choose Admirals, it is very straightforward to evaluate correlation between different financial instruments with the Admiral Correlation Matrix!
The Correlation Matrix is a tool which comes with the FREE MetaTrader Supreme Edition (MTSE) plug-in for the MetaTrader trading platforms.
Once you have downloaded MTSE from Admirals, in order to open the Correlation Matrix, you will need to head to the 'Navigator' window on the left-hand side of the screen and select the 'Expert Advisors' drop down. If the 'Navigator' window is not already there, you can open it by pressing Control + N.
Once open, you can select the instruments which you wish to compare. In this example, we will be looking at four petroleum companies, over the last 500 days, to illustrate a possible stock pair trading strategy.
The Correlation Matrix will display numbers between -100 to 100 between the instruments. If a number is negative, it means the correlation is negative and, if positive, the correlation is positive. A negative correlation means that if one of the instruments goes up, the other one goes down - and vice-versa.
The closer the number is to -100 or 100, the stronger the correlation. A correlation of 0 would imply that there is absolutely no correlation, positive or negative, between the pair - this is a very rare situation.
In the Correlation Matrix, the strongest correlations are shown in red. The matter of what number constitutes a "strong" correlation depends on the trader in question and the pair trading strategy which they have constructed. However, a popular cut-off figure among many traders is 80.
Straight away you will see that there is a high positive correlation between all four of the above stocks. The highest is between the stocks of BP (British Petroleum) and RDSA (Royal Dutch Shell Plc) with a score of 99.
Wait For a Deviation
Now that the strong positive correlation has been established between the two stocks, a trader must wait for a deviation between the two prices.
Let's imagine that the price of BP decreases, whilst the price of Shell remains the same. Now a change in price has been identified, the next stage of our stock pair trading strategy is to initiate a short (sell) position on Shell whilst a long (buy) trade is opened on BP.
We are banking on the prices continuing their historical correlation and have, therefore, covered both bases. If BP's share price rises back towards its previous price, the long trade would profit. If Shell's share price decreases, the short trade part of our stock pair trading strategy would profit.
Of course, this is not an exact science. In our stock pair trading strategy example, it is possible the prices will not realign. The strategy is based on the assumption that historical correlation will continue, but this will not necessarily always be the case.
The MetaTrader Supreme Edition
To benefit from the Correlation Matrix and numerous other Expert Advisors and technical indicators, download the MetaTrader Supreme Edition plug-in from Admirals! This plug-in was created by professional traders and is absolutely free! Click the banner below to start your download today!
Creating a Forex Pair Trading Strategy
In the example above, we looked at the stock market. But we could have easily used the Forex market to create a Forex pair trading strategy instead, or any other financial instrument. The important factor is the strong positive correlation.
To illustrate this point, let's take another example, this time we will look at the Forex market and look to create a Forex pair trading strategy. In particular, we will focus on currency pairs which involve the GBP over the last 500 days.
We can see that the strongest positive correlation is between the currency pairs GBPAUD and GBPNZD which have a positive correlation of 85.
Now we have identified that GBPAUD and GBPNZD are positively correlated, the next step of our Forex pair trading strategy is to wait for a deviation in their price.
In the highlighted section of the chart below, we can see that the price of GBPAUD was moving sideways.
In the GBPNZD chart below, of the same date range, we can see that, in the highlighted section, whilst the GBPAUD price was moving sideways, the price of GBPNZD increased significantly.
Once this upward movement of GBPNZD has plateaued, a Forex pair trading strategy would look to take a short position on this currency pair, whilst entering a long position on GBPAUD.
As we can see from the chart, whilst the price of GBPAUD continues sideways, the price of GBPNZD begins to retrace back downwards towards its previous level before the increase.
This Forex pair trading strategy would have profited from the short position and actually lost money on the long position, as the price of GBPAUD went down. With Forex pair trading strategies, it is not likely that both trades will be profitable. But the aim is for the winning trade, if there is one, to outweigh any loss on the other.
A pair trading strategy can be useful for a trader to have in their trading repertoire, as it can be implemented regardless of market conditions and, as we have seen, in different financial markets.
In the same way, although in this article we have concentrated on a daily time frame, we could have easily shortened this to create an intraday pair strategy, or lengthened the timeframe if we wanted to swing trade, all are valid approaches.
Whatever your trading style, it is always important to test a new trading strategy thoroughly prior to implementing it on the live markets. Fortunately for you, with Admirals, this is possible with a demo trading account.
Risk-Free Demo Trading With Admirals
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.