What is pair trading?

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Pair trading is often called spread trading or statistical arbitrage. The term suggests a strategy for capturing anomalies. In addition, a participant who works on fundamental differences in share prices receives a benefit. The "pair trading" strategy works if the market is stable. Its development is based on the idea of searching for correlated securities. The trader calculates the moment when prices diverge, manages the funds at his disposal very carefully, carefully observing the rules for entering and exiting the market. This allows you to achieve good profits with relatively little risk. There is a special platform for automating pair trading on the MICEX, which allows you to make the workflow easier, more efficient.

Work: difficult but easy

When working with the pair trading method (Yudina or otherwise), a market participant finds correlated securities. Shares whose price is decreasing must be sold, and the money received must be invested in other securities. This is actually self-hedging. Therefore, this logic is effective even when nothing changes in the market. It is believed that one of the main advantages of pair trading on Forts is independence from external conditions.

When downgradedstock market, whose price falls, become a source of income. When the market rises, profits can be made through those securities, the value of which increases. But you need to understand that all stocks with this approach have a pair. When one security from a pair grows, the second becomes a source of loss. With the successful formation of a package of securities, the profit that the trader receives significantly exceeds the losses. A pair trading advisor helps you choose the right set for your portfolio.

Predictability and Reliability

Using this strategy to make money in the stock market is the best way to make money in an environment where stocks tend to fluctuate significantly in value. Reasonable pair trading on Forex turns the situation on the market into a predictable one, which means that it is easier to think over a strategy for making money and get your profit.

Pair trading is a method of forming a predictable trading range for a trader to operate with minimal risk within tight trading boundaries. The key feature of the strategy is the search for the right time, that is, the technology is not suitable for people who are nervous, impatient, unable to wait for the right moment. To some extent, pair trading is comparable to the actions of a spider. You will be patient and attentive enough - and the booty, the profit will be yours. But for this, you will have to wait until the security price goes beyond the normal value.

This is important

When developing your own Forex trading strategy, it is very important to havetheoretical basis. In particular, quantitative methods and methods of analysis in pairs trading are quite different from other strategies.

When choosing in favor of pair trading, trading does not take place in shares, as in the classic version, when a market participant expects to sell the acquired shares at a new price, and the difference between the rates remains in the trader's pocket. But pair trading on "Forts" involves working with pairs of stocks, that is, the strategy differs from the classic version quite a lot.

Randomness takes over the market

The securities market is actively developing, and this is especially noticeable in recent years. For a decade, the Forex market has literally changed beyond recognition. Strategies that worked flawlessly 5-7 years ago now show complete inefficiency. The modern securities market is quite chaotic, and changes in it occur almost by accident, so even specialists cannot predict them in advance. There are periods of calm on the stock market, but they are too short to bet on them. Outside of these "islands of stability" it is difficult to make accurate forecasts. This was the reason for the popularity of pair trading in options and securities.

If a trader builds a strategy on the ability to predict the development of the market, if he chooses only one stock and completely concentrates on it, there is a high probability that the participant in the exchange trade will end up with nothing. Experienced people say that events often developin the opposite direction as predicted. Various books written back in the 90s of the last century are devoted to a similar issue. True, then, with high instability, the situation was predictable, predictable, which cannot be said about our days. The tools offered in those years have lost their relevance, and they were replaced by pair trading indicators, which allow you to really earn money using this Forex trading technique. Pair trading is recognized by many professionals as the most relevant of the existing methods of working on the exchange.

Risk it or not?

Sooner or later almost every trader faces this dilemma. Everyone would like to receive money through Forex, but at the same time everyone would like to avoid risky situations, but not everyone thinks that this is possible. It is no secret that the higher the risk, the greater the probability of earning, and with minimal risk to capital, the trader will not receive anything. But this is the official position, contrary to which pair trading goes against. Of course, it is impossible to completely eliminate losses, even if you use this technique, but it will be possible to minimize them.

Pair trading is a neutral trading investment system based on several (two or more) assets. Beginners believe that this approach is available only to the "sharks of the market", but in fact, you can resort to the technique even when there is no big capital at your disposal. Pair trading has been available to everyone interested for several years now.

Basic Features

WhatWhat does the term "trend neutrality" mean? It assumes the presence of a strategy that is not related to price impulses. Therefore, earnings are possible both with an increase in the price of an asset, and with a fall. But only a well-composed portfolio of securities becomes profitable. Typing "anything", you can not count on success.

Trend identification is one of the main difficulties of earning on Forex. The described system allowed to bypass it. In addition, pair trading allows you to work with different markets, there is no strict binding to the direction. This became the source of such a great popularity of the strategy. The events of 2008, which received the name "Great Recession" in the specialized literature, played a significant role. Practice has shown that pair trading allows you to save capital even in the face of an unpredictable market fall.

Strategy: Approach wisely

The basis of pair trading, as mentioned above, is the correlation of securities. The phenomenon itself has been used for more than a century, it just didn’t have a special term before. For the first time in science, correlation attracted the attention of, oddly enough, biologists, and the concept was formulated back in the 19th century.

The patterns on which pair trading is based are quite complex in terms of mathematics and statistics. However, an ordinary trader does not have to go into such a jungle, it is important to grasp the principle of work. Correlation shows how strongly some quantities are related to each other.(two or more). It is most obvious when two quantities are observed, a change in one of which entails an adjustment in the second.

Scientific approach: is it important or not?

A novice trader might assume that some two stocks are related. Moreover, by examining the numerical values, he may decide that this statement is proved. But this approach is called "by eye" and almost always leads to failure. Scientific research is not carried out “anyhow”, accuracy and regularity are important here. Statistics introduces the concept of "correlation dependence", and also knows several formulas by which the coefficients of connection of quantities are calculated.

Spearman's formula is considered to be one of the most effective in exchange trading. It consists of fairly simple operations, but there are many of them, which makes the calculation a difficult task. So that traders do not have to puzzle over this, the iCorrelationTable indicator was developed. It allows you to evaluate the relationship of two or more securities without resorting to cumbersome formulas.

Though analysis

Using indicators developed by specialists using complex, cumbersome, but precise formulas, one can easily calculate the development of the situation regarding the selected securities. A good indicator will not only analyze the pair given to it, but also provide the user with a complete relationship matrix. At the same time, a trader can set the elements of the matrix independently so that the system provides the most useful data. Optimization of the working profile, and even with simple tools, makes it possibleto master the work in the market faster, and in the future - to reduce the time spent.

The popularity of indicators is not accidental. They are indispensable for pair trading, and it, in turn, is profitable in all markets. Therefore, it is possible to analyze not only Forex trading instruments, but also shares of firms and other CFDs.

Foreign exchange market: how to work?

When choosing assets to work on the foreign exchange market, most often users stop at pairs made up of US dollars, British pounds, euros, Swiss francs. Experienced specialists also suggest paying special attention to these particular currencies. The logic is as follows: the indicated money has a rather obvious relationship, which means that it is enough just to open a cross-rate-position, and you can already work. In the classic version, they combine euros and dollars, dollars and pounds, or euros and dollars, dollars and francs.

Let's imagine the following situation. A certain trader noticed that there is an interconnected pair of currencies and the course dynamics diverge. Suppose the changes are such that they provoke buying a pair of euro and dollar and selling a pair of pound and dollar. The convergence of quotes is such that, as it seems, you can make good money on this. If the volume transactions are the same, then the trader is actually making a synthetic bet on the increase in the euro-pound pair. Pair trading becomes pointless.

Problems and Features

Why does the trader face such difficulties in the described example? First of all, we are talking about risks. The deal isthat a participant in the foreign exchange market is actually facing a volatile cross-rate. In addition, the operation involves additional steps. In fact, it's easier to just buy or sell euro-pound currency pairs. Any DC has this option.

Almost any Forex course used today works the same way. Therefore, when choosing a currency pair, you need to analyze the assets of various trading platforms.

For example

One of the simplest and most illustrative examples is the relationship between the ruble exchange rate and oil prices. The correlation estimate is about -0.97, while the minus shows that the quotes are moving in different directions. If you are going to work with a pair of ruble and oil, a trader must remember that the change in the cost of oil comes first. If we analyze the changes in the exchange rate of the ruble, we can see that they duplicate how the prices of "black gold" have changed. As soon as the energy carrier becomes cheaper, the ruble also loses its price, and it works in the opposite direction.

In addition to the relationship between the ruble and oil prices, analysts monitor the relationship between oil and dollar rates. The relationships within these pairs often do not match. This is due to the global economy, the behavior of the Fed, the Bank of Russia.

The trader's task is to guess the moment when the deviations add up in his favor. Anomalies do not last long, which means that it is important to keep abreast.

Significant Factors

The reasons that destabilize the prices of currency pairs are very different. By choosing an objectearnings, the trader must clearly know what affects the rates, and only in this case he will be able to quickly identify the moments when he will be profitable with the pair trading strategy.

In particular, in relation to the described example, significant events will be periods when large firms pay taxes, sell proceeds in foreign currency, as well as days when external corporate debts are paid. At this time, the demand for the currency of another state from Russian enterprises is growing. As soon as the settlement ends, the market situation will stabilize.

You can make money on pair trading if you catch the fluctuations in exchange rates associated with the statements of the Central Bank, the Fed and other significant structures. Decisions on rates made by the Central Bank also have a certain influence on the situation on the stock exchange.