Pairs trading is a strategic trading option that is used to generate profits regardless of market direction. Traders utilizing the pairs strategy determine two securities that:
Share similar characteristics and have a high positive correlation
Are trading at a price that is contradictory to their historical trading prices
One of the two must be undervalued and the other overvalued, as per their historical trading prices
The trader using the pairs strategy then short sells the security that is overvalued and goes long on the shares of the security that is trading below value. The strategy enables the trader to maintain ultimate neutrality in the market and generate earnings, regardless of whether the market goes up, down, or sideways.
The Process of Selection
Arguably the most arduous and critical step within the pairs trading strategy is the process of choosing the pair to trade. The process of selection – the criteria on which the pair is chosen – is crucial. The selection part of the strategy requires the trader to determine his trading arena – whether he wants/needs to trade securities from a particular industry, companies within a given market cap spread, and other guidelines that help him narrow the field before selecting two securities to trade.
The length of time the trader plans to keep the trade open and his resources are two other important factors in the selection part of the trading process, as it may take quite some time for the trade to move in his favor.
Choosing the Pair, Finding the Correlation, and Understanding the Price Ratio
After establishing the selection criteria and guidelines, the trader must do his homework – use historical data and a variety of financial metrics to get a true understanding of securities within the option pool before making his selection.
Once the trader finds two securities to trade, it is often then wise to test the pair with a short-term trade before committing to something longer. The correlation between the pair, which will be a value between -1 and 1, must be established, so the trader will understand how closely related the pair is to one another. In most cases, traders look for at least a positive 0.8 correlation. The graphic below shows two securities – one indicated by a black line, the other by a red line – showing a close correlation.
The pair’s price ratio – the price of one share divided by the other – must be determined, giving the trader a midpoint that he can chart. Whatever the price ratio is, the trader must watch the market as it moves to see what it tends to do when it reaches the midpoint of the pair. It indicates which security the trader should sell short and which security the trader should buy, and when.
Advantages and Disadvantages of Pairs Trading
While there are a variety of advantages to pairs trading, the most obvious advantageous aspect of the strategy, again, is the fact that a trader has the potential to generate earnings no matter which way the overall market moves.
Pairs trading isn’t without flaws, however. The greatest disadvantage to the strategy is often the fact that when a trader seeks to act on the correlation between the pair to his advantage, the market may not correct within a period of time that is advantageous to the trader. It means that the undervalued equity may not see its true valuation in the market and/or the overvalued stock may remain overvalued.
Pairs trading is widely seen as a neutral position, allowing a trader to stay comfortably in the middle of a trade, generating profit – often substantially – by hedging against any movement the market makes. The reality is that while skilled traders may be able to take advantage of such a position, the market often doesn’t correct itself as speedily as a trader may want or need. For this reason, pairs trading is typically utilized by more experienced traders.