The Pair Trading Strategy Guide

November 26, 2020 11:53 UTC

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!

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 pair trading can be described as a "market neutral" strategy which allows a trader to potentially profit from any market condition.

This trading strategy works 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. Perhaps this is best 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 pair trading 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 each other.

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How to Construct a Pair Trading Strategy

Identify a Pair

Naturally, the first step towards creating a pair trading strategy is to identify two financial instruments which have a high positive correlation. But how does one do this?

It is possible to look at two different instruments and come to the conclusion that, due to a commonality, there may be correlation there. 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 a 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.

Demonstrate the Correlation

For traders who choose Admiral Markets, it is very straightforward to examine the correlation, with the Admiral Correlation Matrix. The Correlation Matrix is a tool which comes with the MetaTrader Supreme Edition plug-in for the MetaTrader trading platforms.

Once you have downloaded MetaTrader Supreme Edition from Admiral Markets, 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.

Depicted: Admiral Markets MetaTrader 5 Supreme Edition - Expert Advisors.

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 pairs strategy.

Depicted: Admiral Markets MetaTrader 5 Supreme Edition - Correlation Matrix

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 traders is 80.

Straight away you will see that there is an incredibly 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.

Let's imagine that the price of BP increases, whilst the price of Shell remains the same. Now the change in price has been identified, a long trade is opened on Shell stock whilst a short trade is opened on BP.

Depicted: Admiral Markets MetaTrader 5 - BP Daily Chart. Date Range: 5 June 2020 - 23 November 2020. Date Captured: 23 November 2020. Past performance is not necessarily an indication of future performance.

We are banking on the prices continuing their historical correlation and have therefore covered both bases. If BP's share price falls again towards its previous price, the short trade would profit. If Shell's share price increases, the long trade would profit.

Of course, this is not an exact science, in this example, the prices might not realign. The strategy is based on the assumption that historical correlation will continue, but this will not necessarily always be the case.

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An Example of Forex Pair Trading

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 a crypto strategy, or a commodities strategy. 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, in particular on currency pairs which involve the GBP over the last 500 days.

Depicted: Admiral Markets MetaTrader 5 Supreme Edition - Correlation Matrix

We can see that the strongest positive correlation is between the currency pairs GBPNZD and GBPAUD which have a positive correlation of 86.

Now you have identified that GBPNZD and GBPAUD are positively correlated, you need to wait for a deviation in their price movements.

In the highlighted section of the chart below, between the dates 31 July 2020 and 7 September 2020, we can see that the price of GBPAUD was moving sideways.

Depicted: Admiral Markets MetaTrader 5 - GBPAUD Daily Chart. Date Range: 30 April 2020 - 23 November 2020. Date Captured: 23 November 2020. Past performance is not necessarily an indication of future performance.

In the GBPNZD chart below, of the same date range, we can see that, between the 31 July 2020 and 20 August 2020, whilst the GBPAUD price was moving sideways, the price of GBPNZD increased significantly.

Depicted: Admiral Markets MetaTrader 5 - GBPNZD Daily Chart. Date Range: 30 April 2020 - 23 November 2020. Date Captured: 23 November 2020. Past performance is not necessarily an indication of future performance.

Once this upward movement of GBPNZD has plateaued, the user of a pair trading strategy would look to take a short position on this currency pair. A long position would be taken up on GBPAUD, which has remained in a sideways movement.

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.

The pair trading strategy would have profited from the short position and actually lost a bit on the long position, as the price of GBPAUD went down. With 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.

Final Thoughts

Pair trading can be a useful strategy for a trader to have in their 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.

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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.

Roberto Rivero
Roberto Rivero Financial Writer, Admirals, London

Roberto spent 11 years designing trading and decision-making systems for traders and fund managers and a further 13 years at S&P, working with professional investors. He has a BSc in Economics and an MBA and has been an active investor since the mid-1990s