Pairs Trading: A Comprehensive Guide
Pairs trading is a trading method where two highly correlated equities are traded with a long and a short position matched.
What Is Pairs Trading
A team of technical analyst experts working for the international investment bank and financial services provider Morgan Stanley created pairs trading in the mid-1980s. The pairs trading approach looks for possible market-neutral earnings by combining statistical and technical research.
Key Highlights
- Pairs trading is where two highly correlated equities are traded with matched long and short positions.
- In the middle of the 1980s, a team of experts who studied technical analysis first proposed pairs trading.
- The foundation of a pairs trading strategy is the historical correlation between two securities; the main factor influencing the method’s profitability is the strong positive correlation between the assets in a pairs trade.
How a Pair Trade Strategy Works
An essential component of a pair trade strategy is market neutrality. Market-neutral strategies include both long and short positions in two distinct, positively correlated securities. The two offsetting positions work great as a hedging strategy that aims to profit from positive or negative trends.
The historical correlation between two assets is the basis of the pairs trading strategy. The main factor influencing the profitability of the approach is the substantial positive correlation between the securities in a pairs trade. The ideal time to use a pairs trading technique is when a trader notices a disparity in correlation. When this connection breaks, the pairs trade can be used since it is based on the historical assumption that the two securities would continue to have a certain correlation.
If an investor is employing a pairs trading technique, they will attempt to take a dollar-matched long position in the underperforming asset and sell short the outperforming security when pairings from the trade ultimately diverge. The convergence of the prices results in profit if the securities revert to their historical correlation.
Limitations of Pairs Trading
Pairs trading has a number of restrictions. One is that a strong statistical connection between two stocks is necessary for pairs trading to work. It might be difficult to find a correlation of 0.80, which is necessary for the majority of pairs trades. Moreover, despite previous prices being not necessarily a reliable predictor of future trends, historical patterns can be. The probability of the predicted result can also be reduced by just requiring a correlation of 0.80.
An Illustration of Futures Pairs Trading
When practicing futures pairs trading the common scenario goes as follows: Futures A and futures B (0.95) provide an example of possible profit. The short-term correlation between the two equities is 0.50, which is different from their historical trending correlation.
By taking a dollar-matched long position in the underperforming contract, futures A, and a short position in the outperforming contract, futures B, arbitrage traders enter the picture. With time, the contracts converge and reach their 0.95 correlation again. The trader closes a short position and gains from a long position.
