What Is Pairs Trading and How to Use It?
Author: Victor Gryazin
Dear Clients and Partners,
Pairs trading is a market-neutral trading strategy that implies buying and selling similar (correlating) trading assets simultaneously.
This method is equally valid for the currency, stock, and commodity markets. The hardest part of this method is choosing the type of assets.
In this article, I will tell you about the main principles of pairs trading, describe basic ways of choosing your instruments, and give examples of using the strategy in the real market.
What is the gist of pairs trading?
Pairs trading is a method based on trading two correlating financial instruments simultaneously in opposite directions.
Correlation is a statistical link between two or more values (assets). It can be direct and inverse. In the first case, one asset basically repeats all the movements of the other one. If the correlation is inverse, the charts of two instruments are mirror-like.
As an example of direct correlation, take the behavior of oil prices and stock prices of oil companies. When oil prices grow, stocks also grow. And vice versa: when oil prices are falling, correlation will stay in place, only in the opposite direction.
However, each oil company will grow or fall in its own way, faster or slower. This temporary divergence of prices can be used for pairs trading.
The strategy of pairs trading uses the principle of balance: it presumes that divergences of correlating instruments tend to return to their average values. Such divergences happen after some important fundamental events: changes in interest rates by Central banks, corporate events, etc.
To trade by the strategy, find a highly correlating pair of financial instruments, one of which has grown/fallen compared to the other. We expect the correlation to restore with time, after which you will close the position.
How to choose instruments for pairs trading?
Choosing assets for this strategy implies using fundamental and technical analysis, as well as statistical calculations. On the whole, you can start to look for instruments for pairs trading among:
- The stocks of companies of one market sector;
- Contracts for similar instruments: Brent and WTI oil, gold and silver, etc.
- Interconnected currencies.
A popular way to evaluate interconnection of two instruments is Pearson’s correlation coefficient. The higher it is, the more it is possible that they will be moving in one direction. Also, we use the notion of cointegration, which is a statistical property of two or more variables that demonstrates the stability of their interrelation.
In this article, I will try not to overwhelm you with mathematical calculations, opting for choosing the assets by graphic analysis. However, mind that this is just one way of choosing instruments for graphic trading, and not the most precise one.
Read more at R Blog - RoboForex
Sincerely,
RoboForex team