Pair trading

Pairs trading: the perfect strategy for market uncertainty

7 mins read

Trading pairs, or using two stocks or other investment vehicles that move in opposite directions of each other, can be an excellent way to mitigate risk and protect your portfolio when the market is uncertain.

Pairs trading strategy exampleAlthough trading pairs has been used as an approach by many successful investors, it’s still an underutilized strategy that isn’t utilized by most investors.

This article will help you understand how pairs trading works and some of the best ways to make use of this approach for your own investments.pair trading strategy python,

What is Pairs Trading?

A pair of traders agree to trade the two stocks in tandem. One trader takes the long position, and another takes a short position. The long-position trader profits if one share rises while the other falls; similarly, if one falls while the other rises, the short-position trader will profit. As risk is also divided, this strategy tends to have a lower potential profit than others but should offer greater peace of mind.

Key things about Pairs Trading

The basic idea of pairs trading is to find a pair of correlated assets with a mispricing that, when combined, cancels out all of the original market risk. A trader with no position in either asset is exposed to no risk and thus achieves zero exposure by buying one share of each asset.

Conversely, a trader holding only one share in either asset will experience an unlimited downside potential.

The historical correlation of two securities serves as the foundation for a pairs trade strategy. The main factor influencing the profitability of the approach is the need that the securities in a pairs transaction have a high positive correlation.

The optimal time to use a pairs trade technique is when a trader notices a discrepancy in the correlation. The pairs trade can be used when the correlation between the two stocks, which is based on historical data, fails to hold a certain level.

A mispricing is defined as any pricing relationship between two assets that deviates from their equilibrium relationship. If they are not correlated and if their price moves are independent, they will have an equilibrium relationship and therefore should not have any mispricing in their prices.

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Advantages and Disadvantages of Pairs Trading.

The primary advantage of pairs trading is that it minimizes risk by allowing you to offset losses by selling shares of another pair. This can be useful when market uncertainties are high. However, there are several disadvantages to pairs trading.

Although it is generally accepted that it is difficult to predict individual stock prices, there is data that suggests it may be feasible to predict the price—the spread series—of some stock portfolios. Making the spread series a stationary operation in the portfolio is a common technique to accomplish this.

In the context of pairs trading, where the portfolios only contain two stocks, one might try to detect cointegration abnormalities between the two stock price series that often exhibit stationary correlation in order to attain spread stationarity.

Forecasts in the opposite direction of the anomaly are made on the assumption that this irregularity will be resolved soon.Thus, it would be possible to incorporate them into a portfolio that features a stationary spread series.

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Pairs trading has a number of restrictions. One is that a strong statistical correlation between two securities is a prerequisite for the pairs trade.

A correlation of 0.80 is needed for the majority of pair trades, which might be difficult to find. Second, although historical trends can be reliable, prices in the past are not always a reliable predictor of future developments. The chance of the expected result can also be lowered by requiring simply a correlation of 0.80.

First, a pair with high expected volatility will yield low profit margins. Second, each share traded generates commissions that must be paid from the amount allocated for investment and management costs – or withdraw funds from the entire fund value before re-investing again.

Third, stock prices change constantly so it is difficult to pinpoint a good entry point in order to execute a trade and get into a position quickly.

How Pairs Trading Be Like?

What pairs trading is and why it works. Pairs trading requires two steps. The first step is called hedging which reduces risk by purchasing some of the same asset at a different time, place or price in order to cover all of your bases should one investment go south.

The second step in pairs trading is called scalping which deals with buying and selling those hedged investments over and over again to make a profit even if only a few trades are made in that day’s span.

Conclusion

The problem with most investors is that they have a proclivity to focus on one security at a time. This could leave them vulnerable to large fluctuations in the values of their holdings. This is how pairs trading algorithm, Pairs traders get around this by buying stocks or assets that move in tandem, hence decreasing any potential risk.

When one asset becomes overvalued, pairs traders can make an adjustment to their holdings and buy stocks or assets that will make up for the loss, ultimately minimizing risk while maximizing return potential.

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