What Is Pairs Trading?
Pairs trading (also known as statistical arbitrage or spread trading), has the potential to achieve consistent profits through simple and relatively low-risk positions. The pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss.
The goal is to match two trading symbol that are highly correlated, trading one long and the other short when the pair’s price ratio diverges “x” number of standard deviations (i.e. the zscore). If the pair reverts to its mean trend, a profit is made on one or both of the positions.
How to decide on a good pair trade is explained step-by-step in a easy to understand one-page pic –>
Click on any pair box to drilldown into more details to analyse it furthur->
NOTE: the Buy/Sell signal above implies for the stock ‘A’
Why Pairs Trading?
Pairs trading is a market-neutral strategy that boasts several advantages:
Since one position is long and the other short, an automatic hedge is created, so even if market or the sector goes down, the losses on the long position will be offset by the gain in the short position.
Profit regardless of market direction
Another attractive feature of pairs trading is the ability to profit whether the market is going up, down or even sideways. This is because the strategy does not depend on market direction, but it’s the relative performance of the two instruments that determines each trade’s outcome.
No directional risk
Because profits depend on the relative price change between the two instruments, rather than from the direction in which each moves, directional risk is removed.
What are the risks involved ?
No strategy can be without risks, else it would be a money-making machine.
What we are trying to bet on is that if a stock outperforms relative to the other, and they generally have always moved together in the recent past, the underperformer should eventually catch up towards the mean & we could make a profit.
But what if the outperformer continues to outrun the other stock because of some specific news or event in that stock? So we must have stop losses in case the crossing of our SD line continues to break through & run away.
And that is why if you observed in our pic above.. the buy /sell signals which the MYFNO.com app auto-generates are only after the ratio AFTER crossing outside the 2SD lines comes BACK inside the band .
Will suggest you to first get confidence in this concept , by trying out some paper trades before actual venturing into real trading . You can also track the pairs you identify to a favourites Pairslist in the myfno app or even enter dummy trades to track in the its portfolio module. All tools in one app 🙂
So happy pair trading !!