Pair Trading Strategy: How to Capitalise on Market Correlations

Introduction

What is a pair trading strategy? Pair trading is a market-neutral strategy involving the simultaneous buying and selling of two correlated assets. In other words, this strategy involves matching two correlated assets, where one has a long position, and the other has a short one. This strategy is based on identifying pairs of assets like stocks, commodities, or currencies that typically move side by side due to market conditions. On the basis of the performance of one asset, the trader can take a position on the correlated asset and gain profit regardless of whether the market is rising or falling.  

It is an effective hedging strategy and a valuable tool for mitigating risk while making sure that a profit can be collected. However, this strategy is not easy to apply to all assets and asset classes as it requires significant statistical calculations and evidence of historical correlations that may guarantee profit. It is a great way to tap into the market without taking on the risk of market volatility. With the long and short position pair-up, this strategy can offset loss on one side with gains on the other.  

How Pair Trading Works

As mentioned, the pair trading basics include identifying two assets that exhibit a correlation. Ideally, these assets should belong to the same asset class, sector, or industry or historically exhibit strong correlations and price movements, but how does pair trading strategy work exactly? The pair trading strategy works by taking a long position in an underperforming asset and pairing it with a short position in an outperforming one. The expectation is that the difference between the prices will eventually revert to the average, where traders can profit from the reversion despite the market’s movements. 

Investors and traders start by conducting thorough market research to identify potential pairs of assets that can be statistically and significantly correlated. This will include examining the price data of both assets through the years, the relation of the price with market conditions, and their price difference. If the price difference, which is also known as the spread, widens beyond a certain threshold point exhibiting a deviation from the norm, traders initiate the pair trade strategy by buying the undervalued asset (going long) and selling the overvalued one (going short). 

This market-neutral approach capitalises on the relative value of the asset rather than directional market trends, which provides an opportunity for profit even in high-volatility markets. 

Indicators for Pair Trading

Traders use a few tools and indicators to successfully execute the pair trading strategy. Following are some of the most commonly used correlation trading tools and indicators:

Correlation Coefficients 

A correlation coefficient is a statistical measure that quantifies the degree to which two assets move in relation to each other under market conditions. The coefficient ranges from -1 to 1, where any value close to 1 indicates a strong and positive correlation, a value of zero indicates no relation, and a value close to -1 represents a strong negative correlation. Any pair that has a correlation above 0.8 is thought to have a high positive correlation and ensures that the assets move together in predictable patterns.  

Moving Averages 

The spread or the price-moving averages between two assets are also a great indicator of pair trading suitability. Traders use these averages to plot and visualise how the pair’s relationship evolves over time. An unexpected and sudden deviation in these averages might be a trading opportunity for traders. 

Bollinger Bands

Bollinger bands measure price volatility and can help determine whether the spread between two correlated assets has moved significantly outside its normal range. If the spread touches or exceeds the outer Bollinger Bands, it might indicate that the assets are overextended relative to their historical relationship, which might be seen as a signal to start a pair trade.

If the insights from the above three pair trading indicators are used collectively, the trader can receive robust confidence in his pair trading decisions and can enhance the strategy’s effectiveness. 

Implementing Pair Trading Strategies

The step-by-step procedure to successfully implementing a pair trading strategy is as follows:

Select a Correlated Pair

The first step is to select a correlated pair by screening different assets, including those from the same or different industries. Next, the data will be analysed using tools, and the correlation coefficients will be calculated. Make sure that the coefficient is strongly positive before proceeding with the pair. Also, ensure that the coefficient remains stable in different markets under different conditions across various time frames. 

Setting Up the Trade 

Next, set up the trade. The best way to do this is by first monitoring the price movement among the pair’s two assets. Use supporting indicators like moving averages and Bollinger Bands to identify when the spread deviated from the norm. Next, determine your entry points based on those indicators and initiate the trade when the situation ripens. Go long on the undervalued asset and go short on the overvalued asset, ultimately keeping the trade market neutral. 

Managing and Adjusting Positions 

Once the trade is set up, it is best to install some enforcements to decrease your risk of loss. Define your exit strategy based on expected and unexpected reversions. Keep a careful eye on external factors like world news or geopolitical tension that could impact the correlation. Finally, adjust the position based on new insights to limit losses. 

By following these steps, traders can successfully identify and execute pair trade strategies and take advantage of market-neutral opportunities. 

Benefits of Pair Trading

Pair trading offers several benefits to traders because of its appealing strategy that minimises risk and maximises potential returns. Here, we look at the main benefits in detail:

Reduced Market Exposure

The pair trading strategy is designed to profit independently of the overall market condition, making it market-neutral. When a trader takes a long and short position simultaneously, the exposure to market-wide risks is greatly reduced, as is the exposure to loss. This can be very useful in markets with high volatility and uncertainty. 

Risk Mitigation 

Risk mitigation is a core benefit of the pair trading strategy. When two correlated assets are traded together, the gains from the putperforming asset offset the loss from the underperforming one. This protects the portfolio by reducing the impact of broader market movements and creating a natural hedge. 

Profit in All Market Conditions

The pair trading strategy allows traders to gain profits regardless of whether the market is trending downwards, upwards, or sideways. The simultaneous trading of a long and short position despite the market conditions creates profitable entry points from which traders can benefit.

There are many pair trading advantages, and the strategy is surely versatile and effective for traders who want to harness the power of correlated asset pairs. 

Risks and Challenges

Pair trading strategies have a lot of benefits to offer. It also offers a few risks and challenges that the trader should be aware of before implementing this strategy in his trading practices. Here are the risks of pair trading strategy:

False Correlations

One of the major risks involved with a pair trading strategy is the probability of identifying a false correlation between two assets. Just because the assets had a strong and positive correlation coefficient and have shown correlated behaviour in the past does not mean that the relation will continue. It is, therefore, not advised to rely solely on historical data without understanding the reasons beyond the correlation. 

Diverging Price Trends 

A pressing challenge in pair trading occurs when the predicted price convergence does not happen. Sometimes, the spread between the two assets widens instead of reverting. This can occur for many reasons, such as the intensity of world news or macroeconomic factors. 

Overexposure to Specific Sectors or Industries 

Usually, the assets in a pair trade belong to the same sector or industry, which can lead to overexposure to sector-specific risks. For example, losses can be seen in both positions if a trader pairs two energy-related assets and new regulatory changes negatively impact the stocks. 

The best way to avoid these pair trading challenges and risks is to closely monitor the positions and regularly adapt and adjust the strategy based on new data. 

Real-World Examples of Pair Trading

There are quite a few successful pair trading real-world examples, and here we explain a few of them:

Coca-Cola (KO) and PepsiCo (PEP)

These two are a classic example of correlated assets. One reason behind this correlation is that they belong to the same sector and have a similar business model and market positions. For years, the pair has shown a strong positive correlation, which the traders have used to their benefit by going long on the underperforming stock and short on the overperforming one. 

EUR/USD and GBP/USD

Popular examples of correlated currency pairs in forex markets include the Euro and the United States Dollar and the Great Britain Pound and the United States Dollar. Their correlation is probably due to their shared relation to the US dollar and economic ties within Europe. Traders can benefit from these pairs by going long on the weaker currency pair and going short on the stronger one. 

Oil and Natural Gas

The oil and natural gas pair is one of the most interesting correlated pairs. They belong to the same sector and are influenced by the global economy and geopolitical events in similar ways. If the price of natural gas surges due to any world tensions while oil remains steady or falls, traders can go long on oil and short on natural gas to get a hefty return to their anticipated spread. 

These were a few real-world pair trades. Before you follow any of these examples, make sure to do your due research and enforce risk mitigation strategies for minimising loss. 

Platforms for Pair Trading

There are a ton of trading platforms that offer pair trading and the necessary tools and indicators to execute such trades. Follow these steps to use the platforms for pair trading:

1. Set up an account on the platform
2. Select the asset pair 
3. Analyse the pair with indicators 
4. Set up the trade 
5. Track and adjust the trade accordingly

Here are some of the most popular pair trading platforms that you can use:

MetaTrader

MetaTrader is probably the most famous trading platform among forex and CFD traders because of its robust capabilities and tools. The platform offers the integration of custom indicators to assess correlations and monitor spreads between pairs, detailed reporting tools, and unmatched automation for efficient execution. 

Interactive Brokers 

Interactive brokers are a go-to platform for experienced traders due to their comprehensive range of financial instruments and advanced trading tools. The platform supports correlation tracking, portfolio management, and custom scripts and algorithms for checking automation and strategies. 

TradingView

TradingView is a popular and intuitive platform offering powerful charting capabilities. One thing to clarify here is that this platform does not facilitate trading but only offers valuable tools and analysis for planning all sorts of trades, including pair trading. This platform offers built-in, community-created, and experienced correlation indicators that can be used to assess relationships between asset pairs. Users can create custom indicators and visualise their spreads to identify entry and exit points. Overall, TradingView is a decent platform to visualise your trades. 

All trading platforms have something to offer. But before you select one of the platforms for your pair trading, make sure that the pair you select is offered on the platform. 

Tips for Successful Pair Trading

Here are a few pair trading tips that you can follow to maximise its effectiveness:

1. Select pairs from different industries or asset classes to reduce the impact of unforeseen events and volatile markets 
2. Set realistic profit targets and avoid holding positions indefinitely in hopes of maximising returns 
3. Monitor the correlation continuously and make necessary changes based on the new data 
4. Use Stop-Loss order to minimise loss 
5. Validate strategies on small capital before investing a big amount 

Improving pair trading success takes time, as trading has a learning curve. To avoid losses, always assess the market and do research before jumping on a trade. 

Limitations of Pair Trading

Understanding the limitations of pair trading can help the trader avoid unwanted situations and optimise their approach. Here are the limitations of pair trading:

Potential Sudden Breakouts in Correlations 

One of the major limitations of pair trading is the potential sudden breakouts in correlations. If two assets are correlated according to historical data, they may suddenly decouple due to unforeseen events like changes in company policies, industry disruptions, or macroeconomic or geopolitical shifts. The best way to go forward in such situations to regularly reevaluate the correlation between trading pairs to ensure that they remain correlated. 

Limited Profit Potential During Low-Volatility Periods

The pair trading strategy capitalises on price differences between two assets. Depending on the sector, the price spread may remain stable in low-volatility markets or periods with zero to minimal movement, significantly limiting the profit potential. Consider employing strategies that work in a more active market with different assets during such periods. 

Over-Reliance on Historical Data

Pair trading relies on historical data to identify correlations. However, solely relying on a pair’s past performance does not guarantee future results. Furthermore, significant shifts in the market or within sectors or industries can deviate from the norm. Combine historical analysis with real-time market data to ensure that the current strategy is valid for pair trading.

These are the few pair trading drawbacks that traders should be aware of before entering a pair trade. However, if a trading strategy is implemented, these limitations can be overcome, and losses can be minimised.

Conclusion

Pair trading is a powerful market-neutral strategy that offers traders a way to capitalise on price differences between correlated assets while minimising the exposure to risks associated with the broader market. By using the long-short approach, traders can generate profit even in volatile markets. 

For traders new to pair trading or just starting out, practising on a demo account is a great way to learn the strategy and implement their pairs in market simulations. Demo trading allows traders to identify correlated pairs, set up long and short positions, and manage and automate trades without risking real capital. If implemented correctly, pair trading can offer traders a way to build a robust foundation for long-term success.