A Beginners Guide to Pairs Trading

The ideal strategy is the one that allows a trader to capitalize on any market, regardless of whether the price is falling or rising. Such trading systems are called arbitrage trading systems. There is true arbitrage and statistical arbitrage. And while the first is available to a vast minority, the second can be handled by every trader.

Pairs trading is a strategy of statistical arbitrage using which a trader opens trades in two financial assets at the same time. Financial assets are related to each other in a certain way. How it is determined and what is needed for this - this is what we will talk about in this article.

What is Pairs Trading

Pairs trading is trading two correlated currency pairs and earning on the difference in rates when the prices of the instruments diverge. What pairs may be called correlated?

Correlating currency pairs are financial instruments that move in the same direction. For example, if one pair is rising, the second pair is also showing growth at the same time. When one begins to fall, the price of the second also decreases. In practice, there is no such ideal correlation. Sometimes pairs begin to move asynchronously. It is a trader's task to timely detect the moment of divergence and enter the market.

The idea of the strategy of pairs trading is based on statistical data. It is based on a statement - if prices of financial instruments have moved according to specific laws in the past, in the future, they will share the same fate. That is if temporarily the rates of correlated pairs diverge after a specific period prices will move synchronously again.

An example of the correlation of currency pairs is shown in the image below based on the AdroFx broker platform. The euro-dollar and pound-dollar charts move the same way.

The type of correlation when pairs move in the same direction is called positive correlation. There is another type of correlation with inverse dependence of financial instruments on each other. In this case, when the rate of one currency pair increases, the value of the other decreases. Such a correlation is called negative. An example of this dependence is a chart of the dollar-franc pair is a mirror reflection of the euro-dollar chart.

How Pairs Trading is Different from Regular Trading

In normal trading (ie usual linear purchase of an asset) the financial result of the trade will depend on the further direction of the price movement: if the price rises - we earn, if the price falls - we lose. In this case, in addition to the task of correctly predicting the trend direction, we need to roughly estimate the depth of a possible correction in order to correctly calculate the size of the position and set a Stop Loss at a level, at which the position will not be taken out due to high volatility. The task is not easy...

The direction of the market in pairs trading is much less important than in linear trading because here, it is more the price deviation between the assets that are traded than the price direction itself.

The basic asset (if we consider it in the linear trade), by and large, has no movement limits, i.e., it can both rise (infinitely) and fall (to zero), while there are price imbalance limits between the interrelated assets and they are very easy to forecast based on the dynamics of the spread between them in the past. It is clear that there can be absolutely any situation on the market, no one gets a 100% guarantee! But the fact is that the maximum deviation of the spread is the value more predictable than the probable change in the price of the underlying asset.

Of course, this does not mean that pairs trading is a panacea against losses as if everything is very simple and easy. But the chance of not getting into deficit is much greater here than in the case of linear trading. The situation in spreads develops much more slowly than in the regular spot market and this gives a certain advantage in time, one can think calmly and take a weighted decision without panic, which can be caused by sharp price fluctuations.

The combination of pairs trading is traded on the same principles as the line chart, but due to the low volatility and technicality of the chart, as well as a better understanding of the oversold and oversold areas than in the line chart of the main asset, the pairs trading is calmer, psychologically comfortable and also has a higher expectation of gains.

Correlation of Stock Exchange Assets

The correlation of stock assets is the relationship between the price movements of two stocks in one sector of the economy or stocks with other asset classes, such as bonds, indices, futures, options, and investment funds. The assets must always belong to the same sector of the economy. The correlation between the two stocks is studied and calculated from data over a considerable period of time, measured in many months or years.  The correlation between two exchange-traded assets is measured by the Pearson correlation coefficient. The average statistical deviations from the average spread values are taken into account when calculating this index. The index values are in the range of one to minus one (+100% -100%). When the index values are higher than 0.7 (70%), the correlation of assets is strongly pronounced. The interval from 0.4 to 0.7 characterizes the average dependence. Values less than 0.4 are weak correlations.  The negative values range shows inverse dependence. The identification of the correlation between the exchange-traded assets allows us to use this data in trading. Diversification is a risk management strategy. The formation of an investment portfolio, with the inclusion of stocks with a high level of correlation, allows you to diversify your portfolio.

Including assets with a negative correlation can meet hedging objectives. For example, the bond market is negatively correlated with the stock market, so investors include stocks and bonds in the portfolio at a certain ratio based on current market conditions. The standard ratio of stocks to bonds in a portfolio is about 70% to 30%. If the market situation changes, the Central Bank's monetary policy changes, or other events affect the national currency rate or market activity, the investor may change the ratio of stocks and bonds. Volatility in the markets leads to capital outflow from high-risk assets to less risky ones; then the volume of bonds in the portfolio increases and that of stocks decreases.  By tracing the dynamics of the interrelations of various instruments, it is possible to adjust the investment portfolio and change trading tactics promptly. This is the trader's work without indicators.

In choosing assets for pairs trading, the trader finds the instruments with historically strong correlation. At a certain moment, there is a breach of the usual correlation, there is a divergence of price movement (spread). Considering the history of assets movement, it can be assumed that prices should return to the previous correlation in the future. Therefore one buys the asset that went down in price and sells the asset that went up in price.   Trading pairs, spreads are traded - the divergence of instruments. Here, it is not so important which direction an individual instrument went, but rather it is more important for the spread to return to zero. An example of a strong correlation is the technology sector stocks AMAT and TER. Applied Materials (AMAT) and Teradyne Inc (TER) specialize in semiconductor products and are part of the NASDAQ index. AMAT's market capitalization is about five times "heavier" than TER.

When you compare the charts, even visually you can tell that the assets are moving in sync. If you place them on the same chart, most of the time, they will be almost identical, especially since they are traded in the same price category, the correlation coefficient of 0.97 is a very high degree of correlation. Such an indicator is suitable for pairs trading.

On the TradingView platform, you can plot the spread of a pair of stocks. There are two options for calculating the spread - the difference or the ratio. To plot the difference between AMAT and TER prices, select AMAT, space, "-" sign, space, and TER in the asset selection window.

At some point, stock prices began to move in the opposite direction - AMAT went up, and TER went down, although until that time the pair was very "friendly", their charts moved in sync. Therefore, AMAT shares are sold and TER are bought. The trade is closed at the moment when the charts converge again. The spread can widen even in the case of unidirectional movement of assets, in this case, one of them is simply increasing or decreasing faster than the other, outstripping its peer. The principle of the trade remains the same - one buys an oversold instrument, and sells an overbought one.

How to Calculate a Position Trading Pairs

When opening a position, the parity of assets is observed, taking into account their volatility. If stocks are bought and sold, their share in the portfolio is calculated taking into account the beta coefficients. A simple system of equations is used for this purpose.

In the stock example, the AMAT beta coefficient is 1.65, for TER it is 1.56.  By substituting the known values into the formula we can determine the share of each asset in the pair. In this case, the AMAT ratio is 0.48 (48%) and TER is 0.53 (52%). Both assets are quite volatile and their betas are not too different. There may be assets with larger differences in a pair, in which case the shares of assets in the pair will also differ considerably. It should be taken into account that the betas of market assets tend to change under the action of various factors. In this case, the specific weight of the assets in the pair is revised. For forex trading, the share of each instrument is calculated based on the pip value. When the pip value is the same for both currency pairs, then everything is simple - trades are opened with the same volume. This is true for the EUR/USD - GBP/USD pair. But there are also other situations. For example, the pip value for the EUR/USD pair in a trade with a volume of 1 lot is $10, for the USD/JPY pair at the moment it is $9.14. The volume of trade with USDJ/PY should be 1.09 (10/9.14) times the volume of a EUR/USD pair to provide the necessary parity.

How to Choose An Asset for Pairs Trading

In pairs trading, positions are opened simultaneously on two assets - currency pairs, stocks, futures, pairs trading of cryptocurrencies, etc.  The main selection criterion is the correlation between the assets.  Correlation can be positive or negative (direct or inverse). In the case of direct correlation, instruments move in the same direction, practically copying each other. This can be exemplified by currency pairs EUR/USD - GBP/USD, or AUD/USD - XAU/USD, oil futures and stocks of oil refineries, and many other variants of positive correlation.

Tools for Searching for Correlating Currency Pairs

There are two ways to determine which pairs correlate with each other at the moment - with the help of correlation indicators or a special online service.

Correlation indicators display information in different ways. Some impose two charts on one screen, while others display an information panel on which you can see which financial instruments are correlated with each other at the moment. It is more convenient to use the first type of indicator. This way you can more quickly see when there is a divergence between prices, and you can enter the market on time according to the pairs trading strategy.

There are also online services. They are easy to use. For the analysis, you need to choose a currency pair and specify the time frame and the number of periods for the calculation. The program will make the necessary calculations and will give you a list of pairs, with which the selected financial instrument correlates. An example of this service is shown in the picture below.

We set the following condition: find correlating pairs on an hour chart of the euro-yen pair, having analyzed 50 nearest hours. The program has calculated the correlation coefficient and displays charts of currency pairs that maximally correspond to the specified parameters. The left side contains a table with the calculation data. The closer the figure is to one, the higher the correlation between the specified instrument and the currency pair from the table.

Pairs Trading Rules

Pairs trading strategy is simple and suitable even for beginners. To enter the market, you need to wait for a certain divergence between the two price charts, and then enter the market by selling the asset, which is rising, and buying the currency pair, which is falling.

After the divergence appears on the chart, the only thing left to do is to wait for the moment when the pairs meet again at a certain point. At this point, both trades should be closed.

The standard scenario is as follows - one of the two pairs usually rises or falls in price more than the other moves in the opposite direction. On one position a substantial yiled is produced, and on the other - small losses. The positive difference is often quite small, but the risks when trading according to the strategy are minimal. Often there are situations when both trades are successful.

To ensure that the pairs trading strategy remains beneficial, it is important to correctly determine the amount of price divergence on the chart at which positions can be opened. This value is calculated as the average of the last year.

Advantages and Disadvantages of Pairs Trading

Advantages of trading interrelated assets:

• This strategy belongs to the market-neutral strategy. Here, it does not matter where the market will go, only the ratio of asset values matters. This allows you to take advantage of market inefficiencies and reduce trading risks.
• The strategy is well suited for system traders who know how to work with large volumes of information. There are great opportunities for algorithmic and robotic trading.
• The system is applicable to all types of markets and all time frames.

Disadvantages:

• The trader has no guarantee that the statistical correlation of the two assets will not be disturbed. This means that the strategy requires strict risk management.
• It takes a lot of time to conduct preparatory work (search for pairs of instruments, calculation of spreads).

Simple Pairs Trading Strategy

The correlation coefficient, which varies from -1 to +1, can be used to select a pair of assets. At the value of +1, assets move in sync, while at -1 there is a negative correlation. It is optimal to choose the assets with a correlation coefficient of 0.75-0.95. At the same time, it is necessary to observe the obvious patterns on the chart of the traded spread.

The next step is to calculate the volume of positions for each asset. This can be done using the ATR (Average True Range) indicator. For example, if the average daily range of one stock over the last month is 10 dollars, and the other is 20, then the volume of positions of the latter must be 2 times larger when opening a position.

The chart for trading (without taking into account the trend component) is obtained by subtracting the day's closing prices from the similar average for 10 days. Levels for placing orders are determined based on the calculation of the average standard deviation of prices for the last 3 years. Lines 1, 2, and 3 of the standard deviations on either side of the zero level should be plotted on the chart.

The strategy implies simultaneous buying of one instrument and selling of the other in the ratio of 2:1 when signal line 1 is reached. At levels 2 and 3 of standard deviations, an addition to the initial position volume is made in the same direction. It is necessary to wait until the zero level is reached in order to secure gains.

Tips For Using Pairs Trading Strategy

Typical mistake traders make when trading with the system of pairs trading is ignoring the calculation of the lot. Often people forget that the lot value of one currency pair differs from the value of a similar volume of another currency pair. In order to enter the market correctly and achieve yield as a result of correct actions, the point value of the two assets should be equal. The lot calculator will be suitable for this purpose. This value can also be calculated manually.

Pairs trading is a trading strategy with minimal risks. Nevertheless, it requires a thorough approach and balanced analysis. Your earnings depends on how correctly you choose trading assets and how exactly you enter the market. It is unlikely that you will receive the golden mountains, but you can generate a small steady return with minimal risk. Remember that the earnings potential of trading depends very much on the broker you choose!

Pairs Trading – How to Start Trading?

So, what steps should be taken to include pairs trading in your market practice? The basis here is to find the dependent assets and graphically draw a curve reflecting this dependence. Further, based on this curve, decisions about entering a trade will be made, as well as statistical analysis will be carried out. It is important to determine a certain starting point or a point that we will take as absolute zero, relative to which we will determine the price deviations.

In addition, for the pair combination to be effective, it is necessary to align both assets with each other by optimizing the position size of each of the assets. The alignment is done based on the volatility of each asset and the value of the movement of one tick. In the case of futures, it is also worth considering the contract date and the amount of the broker's margin requirement to secure the position.

Conclusion

The strategy of pairs trading allows the trader to have a broader view of the market and critically assess how diversified their portfolio is. Like any other strategy, pairs trading, for example, can not guarantee that the trade will go according to the intended scenario. The strong correlation between the two assets, which has existed for years, can be broken one day by some significant external event and no longer recover, contrary to expectations. Nevertheless, pairs trading is the first step to understanding the arbitrage strategies that allow for earning returns while minimizing risks. Using this strategy, a trader must have a clear algorithm of actions, as in the case of favorable development of the situation, as well as in the case the situation unfolds in a negative scenario. Trading according to the strictly set algorithm, quantitative methods and analysis methods, and strict discipline are the important components of successful trading.

About AdroFx

Established in 2018, AdroFx is known for its high technology and its ability to deliver high-quality brokerage services in more than 200 countries around the world.  AdroFx makes every effort to keep its customers satisfied and to meet all the trading needs of any trader. With the five types of trading accounts, we have all it takes to fit any traders` needs and styles. The company provides access to 115+ trading instruments, including currencies, metals, stocks, and cryptocurrencies, which make it possible to make the most out of trading on the financial markets. Considering all the above, AdroFx is the perfect variant for anyone who doesn't settle for less than the best.