Pairs trading is just one of the many trading strategies that can be utilized by many traders. It has its own advantages and benefits as well as certain disadvantages. But if being used in the right way, pairs trading can be considered as a relatively profitable trading strategy that can be used in any type of markets as well as in any type of market conditions.

What Is Pairs Trading?

Pairs trading is a trading strategy that makes use of two correlated securities, hence the word pair. Depending on how the pair of securities is correlated, pairs trading is usually characterized by shorting an outperforming stock and to long an underperforming one. Pairs trading, also known as statistical arbitrage, is based on the belief that when the correlation between two stocks or securities weakens, one of them generally moves up while the other moves down. This can be caused by factors such as temporary changes in demand and supply, market reaction to news from one of the companies, or large buy and sell orders from one of the securities. The spread or difference between the two eventually will converge, but which can be taken advantage of by traders in order to profit.

Versatile Trading Strategy

Pairs trading is a type of market neutral trading strategy, making it quite ideal to use for almost any type of market conditions. Whether the market may be going up, moving down or even sideways, pairs trading can still be utilized for trader to profit. Just like any other type of trading strategy, pairs trading also depends on a number of factors in order to succeed. It requires good market timing, position sizing as well as a trader with good decision making skills.

Basic Pairs Trading

In using a pairs trading strategy, a trader must first try to choose a stock pair. There are many ways in which this can be done. But the simplest way is to find two stocks that not only may be similar, be it in a certain industry or business, but may also be correlated in terms of its price movement.

Choosing A Pair

Once the pairs are chosen, the trader must then try to confirm the possible correlation by checking the trading charts to see how both stocks are performing. A good pair would be moving on the same direction together based on the charts. The next thing that the pairs trader needs to do is to try and create a Price Ratio Chart. This chart is made by dividing one stock price to the other. This chart measures the deviation from the mean or average spread that is found between the two stocks of the pair.

The pairs trader then makes the move once the price ratio line of the two stocks moves to a first or second deviation from the mean. At this point, the pairs trader will be entering into a trade. The pairs trader then will make a long position on the lagging stock while shorting the over performing one. The potential profit may be anywhere in the spread as the two stocks eventually converges back into the mean.