What is pairs trading?

Pairs trading is a popular market-neutral strategy used by traders to profit from relative price movements between two correlated assets. Unlike traditional trading, which involves betting on the direction of a single asset, pairs trading focuses on the price relationship between two assets. It’s a strategy that involves simultaneously buying one asset while selling the other, with the goal of profiting from the price difference between them. But how does pairs trading work, and what makes it so appealing? Let’s explore this strategy in more detail.

1. What is Pairs Trading?

Pairs trading is a type of statistical arbitrage strategy that involves identifying two stocks or assets that have historically moved in a similar way, meaning they are highly correlated. The idea is to take advantage of temporary divergences in their price movements. If one stock in the pair moves higher or lower than expected relative to the other, the trader can take a long position (buy) in the underperforming asset and a short position (sell) in the outperforming asset.

The goal is that when the prices of these two assets eventually converge (or the price relationship normalizes), the trader profits from the price difference. Since pairs trading is based on the relative performance between two assets, it is often seen as a market-neutral strategy, meaning it doesn't rely on the overall direction of the market (up or down). Instead, it focuses on the relative movement of the two assets.

2. How Does Pairs Trading Work?

The process of pairs trading involves several key steps:

• Asset Selection: The first step is selecting two assets that are highly correlated. This means their prices tend to move in the same direction over time. For example, two companies in the same industry, like Coca-Cola and Pepsi, or two oil stocks might exhibit strong correlation. Traders often use statistical tools like the Pearson correlation coefficient to identify pairs with a high correlation.
• Identifying Divergences: Once a pair is selected, the next step is to monitor their price relationship. When the price of one asset deviates significantly from its historical relationship with the other, it creates an opportunity. For example, if one stock has risen sharply while the other has remained flat, it might signal that the first stock is overvalued or the second stock is undervalued.
• Taking Positions: In pairs trading, the trader will take opposite positions in the two correlated assets. If the price of one asset has risen relative to the other, the trader might short (sell) the outperforming asset and go long (buy) the underperforming one. The assumption is that over time, their prices will converge back to their historical relationship.
• Exiting the Trade: The trade is exited when the price relationship between the two assets normalizes. This means that the two assets return to their typical correlation, and the price gap closes. At that point, the trader can sell the long position and cover the short position, hopefully securing a profit.

3. Example of a Pairs Trade

Let’s look at an example to better understand how pairs trading works:

Suppose two companies, A and B, are in the same sector and have historically moved in tandem. Over the past few years, they’ve shown a high correlation, meaning when Company A's stock price goes up, so does Company B's, and vice versa. One day, Company A reports strong earnings, and its stock price rises 5%, while Company B’s stock price remains flat. This creates a price divergence between the two stocks.

A pairs trader might decide to short Company A’s stock (because it is overvalued) and buy Company B’s stock (because it is undervalued relative to Company A). The expectation is that, eventually, the price gap between the two stocks will close. Once the price of Company A falls or Company B's stock rises, the trader can exit the positions and pocket the difference.

4. Advantages of Pairs Trading

Pairs trading offers several benefits for traders:

• Market-Neutral Strategy: One of the main advantages of pairs trading is that it is market-neutral. This means that it doesn’t rely on the overall direction of the market. Even if the market is experiencing a downturn, pairs traders can still profit from the relative price movements between the two assets, as long as their relationship returns to normal.
• Reduced Risk: Since you are taking opposite positions in correlated assets, the strategy can help reduce risk compared to outright buying or selling an individual asset. The potential for large losses is minimized because gains from one asset can offset losses from the other.
• Diversification: Pairs trading allows traders to diversify their portfolios by taking advantage of opportunities across different assets or markets. It can also be used to trade across different sectors, industries, or even different countries.
• Profit from Divergences: Pairs trading allows traders to profit from market inefficiencies or temporary divergences in price. Even if the overall market is flat, traders can find opportunities in individual pairs that are mispriced.

5. Risks of Pairs Trading

While pairs trading offers several advantages, it also comes with its own set of risks:

• Correlation Breakdown: The biggest risk in pairs trading is the breakdown of the correlation between the two assets. If the relationship between the two assets changes permanently, the price convergence may not occur, leading to potential losses.
• Market Volatility: While pairs trading is market-neutral, sudden and unexpected market movements can still affect the trade. For instance, if there’s a market-wide event that impacts both assets, the trade may not work as expected.
• Execution Risk: Since pairs trading requires quick execution of trades, any delays in execution or poor trade execution can eat into profits. This makes it essential to have fast and reliable systems for trading.
• Liquidity Risk: Liquidity is also a concern, especially when trading in less liquid markets. If there is not enough volume in one of the assets, it can be difficult to enter or exit the trade at favorable prices.

6. Conclusion

Pairs trading is an effective strategy for traders looking to profit from the relative price movements between two correlated assets. It offers a market-neutral approach, which reduces reliance on overall market trends, and allows traders to make profits even in flat or volatile markets. However, like any trading strategy, it comes with risks, particularly the risk of correlation breakdown and market volatility. By carefully selecting pairs, monitoring price relationships, and executing trades swiftly, traders can use this strategy to potentially generate consistent profits.