The first in-depth analysis of "pairs trading"
Traders have hundreds of technical tools and price action strategies to help them take advantage of price trends and ranging markets, but pairs trading is something completely different. Pairs trading uses correlations and divergences between two stocks in an attempt to capture a profit. While it isn't riskless, by understanding how pairs trading works, how you control risk and how you manage profits, it's a great tool to add to your trading arsenal because the strategy isn't dependant on market direction.
What is "pairs trading" ?
Pair trading is a market neutral strategy which enables traders to be profitable in all market conditions such as uptrend, downtrend or sideways movement. This strategy involves statistical arbitrage of two highly correlated stocks preferably in the same segment having the same macro dynamics, which has temporarily diverged i.e. one stock moves up while the other moves down, the pairs trade would be to short the outperforming stock and to long the underperforming one, betting that the pair would converge. The divergence in the pair could be caused by temporary supply/demand changes, large buy/sell orders for one stock, reaction for important news about one of the companies, and so on.
Pairs trading is a market-neutral strategy in its most simple form. The strategy involves being long (or bullish) one asset and short (or bearish) another. If properly performed, the investor will gain if the market rises or falls. Pairs Trading reveals the secrets of this rigorous quantitative analysis program to provide individuals and investment houses with the tools they need to successfully implement and profit from this proven trading methodology. Pairs Trading contains specific and tested formulas for identifying and investing in pairs, and answers important questions such as what ratio should be used to construct the pairs properly.
Why Pairs Trading Works ?
Co-integrated pairs are assumed to be mean reverting in nature.
Once the spread diverge from its mean, the probability of reversal increases.
With the chosen pair from the same industry and sector the extreme divergence from the mean are very rare.
The strategy’s profit is derived from the difference in price change between the two instruments, rather than from the direction in which each moves.
Statistical arbitrage is based on the assumption that the patterns observed in the past are going to be repeated in the future.
The natural extrapolation of pairs trading strategies consists of the operation of a group of stocks against another group of stocks, or generalized pairs trading.