When trading, there are plenty of strategies one can employ to profit from the financial markets. However, there are no guarantees, as every strategy carries its own risks. Some strategies are more assured than others, meaning the trader stands to make fewer losses even if the trade goes against them. One such strategy is pairs trading. It entails the simultaneous buying and shorting of two assets that are highly correlated. Traders opting for this strategy aim to profit from the expected convergence of the two asset prices.
Pairs trading is only applicable when a trader believes the price of the two assets will eventually converge. When this happens, they can proceed to close out the positions and lock in the profit. That said, pairs trading is a market-neutral strategy that doesn’t rely on the overall direction of the market, which makes it a relatively low-risk strategy, even though there is no strategy without risk.
Learning how to pairs trade is vital to making the most of this strategy. At its core, there are a few key considerations to make it applicable. For instance, the two assets have to be highly correlated, which means they should move together in a similar way over time. The two assets also must be liquid, allowing traders to buy and sell easily without impacting the price. Finally, a trader has to identify the right entry and exit points by carefully analyzing the historical price data of the two assets.
If you are wondering what kind of assets make the best pairs trade, these include those from the same industry, such as Apple and Microsoft; two ETFs that track the same index, such as the SPDR S&P 500 ETF and the iShares S&P 500 ETF; two currency pairs, such as USD/JPY and EUR/USD; two commodities, such as gold and silver; and so on.
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The History Of Pairs Trading
Pairs trading has been around for a while, first appearing in the 1980s thanks to a group of technical analysts who were employed by Morgan Stanley. It was developed by Gerry Bamberger and his team at the renowned bank. The team came up with a statistical arbitrage trading strategy that used pairs of stocks that were highly correlated. During their study, they realized that the pairs of stocks would often diverge in price before eventually converging back to their historical relationship. The discovery allowed the team to buy the undervalued stock and short the overvalued stock, as they expected to profit from the convergence of the prices.
The strategy would prove quite successful in the 1980s, helping Morgan Stanley become one of the leading players in the quantitative trading space. But with time, other investment banks and hedge funds emulated it, and the profits began to dry up. By the next decade, the strategy would get more sophisticated as traders employed more complex statistical techniques to identify and trade pairs of stocks to gain an edge. Stiff competition and the development of new trading strategies continued to pose a threat.
Today, the strategy is still popular, but not as much as it was in the past. It’s still profitable, but traders need to understand the risks involved before choosing to use it.
Advantages Of Pairs Trading
Pairs trading presents several distinct advantages that make it an attractive strategy for investors and traders alike;
- Pairs trading is a market-neutral strategy that doesn’t rely on the overall direction of the market, which makes it a relatively low-risk strategy.
- Can be used to hedge against risk by buying the undervalued asset and shorting the overvalued one.
- If done correctly, it can be profitable.
- The pairs boast liquidity allowing for easy buying and selling without impacting the price.
Disadvantages Of Pairs Trading
While pairs trading offers appealing advantages, it also comes with certain drawbacks that traders must carefully consider;
- The pairs have to be highly correlated; otherwise, the trader stands to lose money.
- Identifying the right entry and exit points might be problematic.
- It can be costly, as traders need to pay commissions and fees for each trade.
- Can be highly volatile as the prices of the two assets can fluctuate rapidly.
That said, pairs trading is a complex strategy that can be profitable if done correctly. But one needs to understand the risks involved before they start trading.
