The Pairs Trading Strategy Guide
Pairs 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 about what a pairs trade is, how to create a pairs trading strategy and more, read on!
Table of Contents
What Is Pairs Trading?
A pairs trade involves opening two positions, one long and one short, in two different instruments, which have a high positive correlation.
Firstly, a trader must find two different assets which have a demonstrably high positive correlation. Once identified, the trader waits for a divergence in the instruments’ prices, at which point they can attempt to profit by employing a pairs trading strategy.
In order to do so, the trader would enter two different positions: a short position in the instrument which is outperforming and a long position in the instrument which is underperforming.
Pairs trading strategies are based on the assumption that, if two financial instruments have had a positive correlation in the past, they will continue to do so in the future. In other words, our pairs trader assumes that, following the divergence, the prices of the two assets will move back towards each other, hopefully resulting in a profit in one or both of their positions.
Pairs Trading Example
As is often the case, pairs trading is perhaps best understood by looking at an example. So, if you found our definition of pair trading difficult to follow, don’t worry, hopefully this section will clear things up.
Let’s say that a trader identifies that the share prices of Company A and Company B have a high, positive correlation (we’ll demonstrate how to identify assets with high, positive correlation in the next section).
Despite this historically positive correlation, the prices of these two companies begins to diverge, with Company A’s share price rising whilst Company B’s share price falls.
Consequently, our pairs trader steps in and opens two positions: they short Company A, the outperformer, and buy Company B, the underperformer. Assuming that the prices of these companies converge and resume their positive correlation, we can identify three possible scenarios.
- Company A’s share price falls, resulting in the trader’s short position profiting.
- Company B’s share price rises, meaning the trader’s buy trade turns a profit.
- Company A’s share price falls and Company B’s share price rises, resulting in both trades turning a profit.
How to Create a Pairs Trading Strategy
Now we have a better understanding of what pair trading is, let’s take a look at how to create a pairs trading strategy.
Identify Trading Pairs
The first step towards creating a stock pairs trading strategy is to identify two companies which have a high positive correlation. But how can you do that?
With stocks, a good place to start is by looking at companies which operate in the same industry. For example, it would be logical to expect the share prices of consumer goods companies Coca-Cola and PepsiCo to be positively correlated. We could say the same about US automakers Ford and General Motors.
Demonstrate Correlation
The Admiral Markets Correlation Matrix, which comes with the free MetaTrader Supreme Edition plug in for MetaTrader trading platforms, allows traders to analyse correlations between different financial instruments.
In this example, we are looking for possible trading pairs amongst oil and gas majors. The Correlation Matrix below shows the correlation between five different companies over the last 1,000 days.
The Correlation Matrix displays numbers between -100 and 100. A score of -100 would imply a perfectly negative correlation, whereas a score of 100 would demonstrate a perfectly positive correlation. A score of zero would imply that there was absolutely no correlation whatsoever.
As we might expect, given that all the companies operate in the same industry, they are all positively correlated which each other to varying degrees, with the strongest positive correlations highlighted in red.
With a score of 95, BP and Shell enjoy one of the highest positive correlations.
Wait for a Divergence
Now that the strong positive correlation has been established between the two stocks, a trader must wait for a deviation between the two prices.
One way in which traders can identify a divergence in prices is by examining the historic ratio of the two prices. The chart below shows the weekly price ratio between Shell and BP (calculated by dividing Shell’s share price by BP’s share price) over the last five years.
The price ratio has mostly remained within a range of 4 and 5.6, with the average price ratio (4.92) highlighted in purple on the chart.
A pairs trading strategy may dictate that, once the price ratio reaches the upper end of the range, meaning that Shell is outperforming BP, the trader buys BP and shorts Shell. On the other hand, if the price ratio nears the lower end of the range, meaning that BP is outperforming Shell, the trader might choose to buy Shell and short BP.
Final Thoughts
A pairs trading strategy can be useful for a trader to understand, as it can be implemented regardless of market conditions and in different financial markets.
However, it assumes that because two assets have been positively correlated in the past, they will continue to be so in the future. This isn’t necessarily true. Whilst many traders use historic price data to help predict future price movements, past prices are not a reliable indicator of future results.
Just because two assets have been positively correlated in the past, it does not necessarily mean they will always be positively correlated.
Trade on a Risk-Free Demo Account
Want to practise using a pairs trading strategy without risking your money?
A demo trading account is a great place for a beginner trader to get to grips with the financial markets, or for an experienced trader to trial a new strategy. Click the banner below to open a demo account today:
FAQ
What are the disadvantages of pairs trading?
Pairs trading involves short selling, which is typically done using financial derivative products such as Contracts for Difference (CFDs). Holding a short position usually incurs an interest charge, which can add up if held for a longer period.
About Admiral Markets
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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.
