Pair trading is the strategy that involves buying and selling two related securities, such as stocks, simultaneously to profit from their relative price movements. The strategy capitalizes on temporary divergences in prices between two assets that have a strong historical correlation.
Here’s a step-by-step overview of the pair trading process:
1. Pair selection: The first step is to identify a suitable pair of securities that exhibit a high degree of correlation. It’s important to select assets with similar characteristics like industry, market capitalization, or other relevant factors.
2. Calculating the spread: Once the pair is chosen, the spread between the prices of the two securities is calculated. The spread can be determined as the difference in prices or the ratio between the prices of the two assets.
3. Establishing a trading signal: Traders often employ statistical measures such as z-scores or standard deviations to identify when the spread deviates from its historical average. When the spread widens or narrows beyond a predetermined threshold, it generates a trading signal.
4. Opening positions: If the trading signal indicates an opportunity, the trader takes a long position (buy) on the underperforming security and a short position (sell) on the outperforming security. This strategy allows the trader to profit from the convergence of prices when the spread narrows.
5. Monitoring and managing the trade: Once the positions are established, the trader closely monitors the spread between the two securities. If the spread behaves as anticipated, the trader may decide to close the positions and secure profits. Risk management techniques, such as stop-loss orders, can be used to limit potential losses.
It’s important to understand that pair trading carries inherent risks, and the success of the strategy can be influenced by market conditions. Adequate research, ongoing monitoring, and effective risk management are crucial for successful pair trading. Traders also utilize advanced quantitative models and algorithms to automate the process and enhance trade execution efficiency.
