Traders have hundreds of technical tools and price action tactics that help them exploit price trends and market ranges, but it is infamously difficult to anticipate the direction of short to medium market movements. This is why some traders are moving toward more market-neutral methods that may deliver gains regardless of the movement of the market. Pairs trading is one of the most common tactics.

Pairs Trading is a market-neutral strategy and involves combining long and brief positions with strongly correlated stock. This means that market direction doesn't matter.

The pair trade is an intelligent pairs trading strategy that Morgan Stanley and Co have put together as a group of mathematicians, computer scientists and physicists. These researchers devised an automated trade programme to exploit short-term market instabilities and initially deployed what is now referred to as pairs trading, created with the purpose of researching arbitration possibilities. Here's how a technique for pairs trading seems.

What are the origins of Pair trading?

A group of computer scientists, mathematicians and physicists established by Morgan Stanley & Co. in the mid-1980s is widely attributed with the first trade of this kind. The team studied the possibilities of arbitration, using state-of-the-art statistical modelling and developed an automated pairs trading scheme to exploit momentary market imbalances.

While the black box of the team was successfully transferred in 1987 – for Morgan Stanley, the group gained $50 million profitably, the next two years of trade showed insufficient results to the effect that in 1989 it dissolved!

Good things come in pairs, for pairs trading

Simply said: when the relationship is deemed to have (temporarily) lessened, two stocks whose price movements have been very connected take a long stand and a short simultaneous position in the other.

It seems like the two intoxicated brothers walked down a road in a famous Hindi film, drifting away for a while when the alcohol came in, and ultimately returning together once healthiness restored! Similarly, when the correlation returns to its typical history, a profit is achieved in pair trading.

Statistical arbitration pairs trading is a stock trading strategy that is extensively used for producing market-neutral returns by hedge funds. Pairs Trading is the easiest and popular variation of the approach. The pairs trading strategy includes identifying asset combinations that are expected to have a long-term balance.

If the spread has sufficiently differentiated from the value of the balance, it makes a profit by placing a long-lasting short position on that pair, if the spread returns to balance by unwinding. Similar concepts control more complex strategies that take into account a wider asset basket

How to make the pairs trading strategy?

The first stage for pairs trading is to choose two equities that show a significant connection in price movement. The first stage is to choose the pairs trade. As a beginning point many traders in the same business or even better, inside the same industry group will be looking for stocks.

In unrelated industries, stocks tend to be weaker than in the same industry. For instance, when RBI raises interest rates, all corporate banks would also be affected in the same manner and if rates are dropped and hence more connected than across equities in the business.

Examples for pairs trading strategies

Once the corresponding pairings are listed, the historical spread or price ratio is calculated.

The spread of the price (difference of prices – for example, between Hero Motor and Bajaj Auto prices were average historical differences Rs0 on both sides and extreme Rs 600 differs) or prices ratio (price A divided by price B – if Rs 3000 moto trades and Rs 2700 car trades on Bajaj, then the price ratio is 3000/2700=11x). Premium prices are the same as the cost of cars.

What are the pros and cons of pairs trade?

Pros include a market-neutral investment strategy. There has to be minimal consideration or time to analyse wider market circumstances. The method is also extremely versatile because short-term dealers can utilize less than a standard deviation or shorter time frame for triggering additional trade signals (i.e. a 30-minute diagram).

Otherwise, it may take a long time for a discrepancy or, based on fundamental changes in corporate structure or performance, prices might simply continue to differ. Therefore, a risk limit must be established to avoid disasters in which both stocks are continuing to shift farther and farther out of sync.

The pairs trading approach is also counter to the standard notion of trend pairs trading in the sale of stronger stocks and the weakest – the other way round is with peer trading. Then sometimes it's awkward and unintended for pairs trading!

Traders also need to take a stock beta into consideration. There is a volatility disparity between the two identical equities with extremely different betas. It might create problems with commerce if one stock is substantially more volatile than the other. Ideally, pairings of equities with connected equities with similar betas.

One of the limitations of a pair trading strategy consists of the fact that the trader is unable to ensure the temporary connection between two equities. As a result of fundamental changes in a corporation, it might last longer than expected.

This risk can be handled by establishing an end to lose that leaves trading automatic when equities are separated from each other. Another drawback is that finding a pair of shares with a historical connection makes this pairs trading method more accessible to experienced traders is hard to achieve.

Understanding the statistical arbitrage

Once two securities have been traded by the pairs trading trader it is frequently prudent to test the pair with a short-term business before engaging in a longer business. It is important to establish the relationship between the pair which is between -1 and 1 so that the dealer understands how close the pair is linked to each other.

Traders usually search for a 0.8 correlation at least positively in pairs trading. The graph below demonstrates the tight association between two securities – one denoted by a black line and the other by a red line.

The procedure of picking the pair to trade is perhaps the most demanding and crucial phase in the pair trading approach. The selection procedure — the criterion for the partnership – is vital. The selection component of the technique involves the trader establishing his pairs trading arena - whether he wants/needs to trade securities from a certain industry, firms within a specified market size spread, and other parameters that help him restrict the field before picking two stocks to trade in pairs trading.

Conclusion

The pairs trade is often considered to be a neutral position which makes it possible for a trader to be comfortable with a transaction and earning profit by hedging from every movement of the market – often considerably.

In fact, the pairs trading market often does not correct itself as quickly as a trader wants or needs, while expert traders can take advantage of a position of this kind. This is why more experienced traders usually use pairs trading.