A Comprehensive Guide on Pair Trading

Pair trading is a sophisticated market-neutral strategy that capitalises on price inefficiencies between two highly correlated securities. By leveraging historical correlations, traders aim to benefit from temporary deviations in the price relationship between these stocks, anticipating that they will revert to their mean over time.

It is a trading strategy investors use to make profits from short-term fluctuations in competitors’ share prices. This is a smart technique for traders to diversify their portfolios and mitigate risks. In this blog, we will talk about what pair trading is, its working, advantages and more.

What Does Pair Trading Mean?

Pair trading is a market-neutral strategy involving long and short positions in two highly correlated securities. It capitalises on temporary deviations in their price relationship, betting on a return to historical norms. 

Traders identify stocks with strong correlations, often within the same sector, and take opposite positions when these correlations weaken. By shorting the outperforming stock and buying the underperforming one, traders profit from the eventual convergence of prices. 

This strategy helps mitigate market risks and can generate returns in various market conditions. It requires careful stock selection and market monitoring to execute effectively.

How Does The Pair Trading Strategy Work?

Now that you know what is pair trading, you must understand how it works. Pair trading involves selecting two competitive companies and simultaneously taking a long position in one and a short position in the other. 

A long position is held when an investor expects the stock to rise, while a short position is taken when anticipating a price drop. By buying and selling these positions simultaneously, investors can profit from both companies as they revert to their historical price relationship.

This strategy mitigates risks by balancing long and short positions, though its effectiveness can be impacted by market fluctuations. For pair trading to succeed, the companies must return to their original price correlation after a temporary deviation, allowing investors to benefit regardless of whether both stocks rise or fall together. 

Advantages of Pair Trading

Now we know what pair trading is and how it works. Moreover, here is a list of insightful benefits that will help you decide your future trading techniques.

• Market Neutral Trading Opportunity

Pair trading offers a market-neutral strategy that significantly reduces the risk of trading losses by allowing investors to hedge against market downturns. By taking both long and short positions in two competitive companies, investors can often rely on the historical correlation between these stocks to revert over time. This approach enables traders to easily reverse their positions to avoid losses if needed.

• Liberation from Dynamic Market Trends

This strategy focuses on profiting from the divergences in share values between two correlated companies, freeing investors from the need to analyse broader market trends and their underlying drivers. By concentrating on the relative performance of these stocks, traders can generate returns without needing to predict overall market movements.

• Mitigates Risk

Pair trading substantially reduces risk by combining long and short positions in competitor companies. It shields investors from the uncertainties of market trends and the potential for uninformed trading decisions, providing a more stable and predictable investment environment.

Challenges and Threats in Pair Trading

Incorporating pair trading into an investment strategy comes with several challenges and potential threats:

• Extensive Research and Analysis

Despite being insulated from broader market trends, investors must conduct thorough research and analysis on the behavior of competitor companies. This involves meticulous comparison and scrutiny of past market data, which can be time-consuming, often requiring weeks to months of study.

• Market Disruptions

Sudden market events can cause significant fluctuations in the share prices of competitor companies, disrupting the strategy. It may take considerable time for the price relationship to normalise, posing a risk to the investment.

• Limited Affordability

Pair trading often involves top-tier companies with high-priced shares, such as Coca-Cola and Pepsi. This limits accessibility for investors with limited financial resources, making it challenging for everyone to adopt this strategy.

• Uncertainty

While pair trading aims to profit from discrepancies in share prices, future market movements are inherently unpredictable. Past performance can provide insights but does not guarantee future outcomes, adding uncertainty to the strategy.

Elements of Pair Trading

Here is a list of key elements of pair trading that help to develop the strategy.

• Competitor Securities

This trading strategy consists of two companies that relate to each other very closely. And have similar goals, driving factors and similar share prices.

• Relationship

An abstract element of this strategy is the relationship between these companies. Investors come to understand this element after their research and analysis on both companies.

• Relationship Deviation

Share value of both companies are at parity with each other but sometimes news or other events in the market prefer one company more than the other. This creates 

• Effect of Deviations

Generally, deviations as a result of minor news and activities cause a short-term effect on share price parity. A sudden sale or rise in the price of the product because of sudden demand can cause these differences. Pair traders seek these opportunities to make a profit.

Strategies to Incorporate a  Pair Trade

Here are the steps to strategically execute a pair trade.

• Identify a Pair in The Market

Select two companies from the same industry and sector that have been correlated in the past for a long time. Check their behaviour and analyse it based on different timeframes.

• Scrutinise Their Correlation

Use statistical mathematics to calculate their correlation, coefficients and cointegration and test their relationship status. The calculation of these statistical maths should be at least 80% correlated.

• Evaluate The Spread and Set Entry Conditions

Identify a spread in their prices, compare it with similar spreads in previous spread occurrences and identify your expected spread. Set a threshold to finalise your end of trade.

• Start The Trade and Monitor Your Position

Start your trade according to your research and continuously monitor your spreads while evaluating external factors of spreads.

• Exit Trade

Close positions of trade once you reach your desired threshold. Implement plan B strategies to mitigate risks if things go differently.

Final Thoughts

Pair Trading can be a very profitable trading technique to earn great profit with fewer risks. The better thing is it does not require much research and effort when you are trading a pair for a long time. Moreover, advancements in technology highly streamlines the comparison and research work. 

Torus Digital provides streamlined Demat account opening services and a customised 3 in 1 trading and savings account. Start trading with Torus Digital today and implement profitable trading techniques such as pair trading.

Frequently Asked Questions

• Is pair trading suitable for beginners?

This type of trading can be suitable for beginners. However, it completely depends on that investor’s market understanding and knowledge. One must be able to analyse different sets of factors and combine them to come to a conclusion.

•  How do I find the best stock pairs for pair trading?

Investors need to make a thorough scrutiny of both the companies. They must analyse the company’s correlation fundamentally and statistically. Pair correlation must be 80% as per statistics.

• Can pair trading be automated?

Yes, one can automate this trading strategy by incorporating algorithms and utilising appropriate software. This helps in faster execution and ease of trading if one can trust this software.

• What are the best tools for pair trading analysis?

Torus Digital provides a hassle-free Demat account creation. You can use your Demat account and utilise its excellent interface to analyse and incorporate a pair trading strategy.