Pairs Trading: Definition and Examples

Pairs trading is a sophisticated approach to investing that’s flexible and adaptive in volatile market conditions.

In this guide, we’ll discuss what pairs trading is, its benefits and drawbacks, and how to create a pairs trading strategy. We’ll also illustrate an example to solidify your understanding.

What is pairs trading?

Pairs trading is a complex trading strategy involving the simultaneous purchase and sale of two correlated financial instruments. The objective is to capitalize on the price difference between the two assets, exploiting the relative performance of two securities at once. 

For example, within Composer, traders can access an array of symphonies designed to invest equally in two highly correlated assets, making executing pairs trading strategies more accessible and efficient. 

Check out composer.trade and dive into the mechanics and potential of pairs trading, looking additionally at how Composer can elevate your trading experience and help you make successful pairs trades. Sign up for a 14-day trial today.

Pros and cons of pairs trading

Pairs trading offers unique advantages and faces certain challenges. Weighing these pros and cons to understand how pairs trading might fit into your overall investment strategy is important. Here's a breakdown of the key advantages and disadvantages:

Advantages

Reduced market risk

Pairs trading helps hedge against and profit from overall market movements. By simultaneously taking long and short positions on two correlated assets, traders aim to minimize the impact of broader market shifts. This can be particularly attractive during periods of high market volatility.

Profit potential in various conditions

Unlike some trading strategies that predict the market’s direction, pairs trading focuses on relative performance. This means traders can generate profits regardless of whether the overall market is trending up, down, or sideways—a distinct advantage.

Capitalizes on market inefficiencies

Pairs trading seeks to identify temporary mispricing between related assets. When the correlation between two assets temporarily deviates from historical norms, pairs traders see an opportunity. By exploiting these inefficiencies, traders can profit from the correction as the assets revert to their usual correlation.

Disadvantages

Continuous monitoring

Successful pairs trading tends to require constant vigilance. Traders need to closely monitor their positions to detect any deviations in the correlation or relative performance between the paired assets. Failing to do so can result in losses and/or missed opportunities.

Unexpected market movements

No trading strategy is totally immune to unforeseen market shifts or external events. Sudden and unexpected changes in conditions can disrupt the correlation between paired assets, even if they have historically been closely related. Such disruptions can lead to unexpected losses or increased risk. 

Correlation breakdown chances

Obviously, pairs trading strategies rely heavily on historical or statistical correlations between assets. However, these correlations can break down due to changing market dynamics, shifts in economic conditions, or other unforeseen factors. When the correlation between paired assets weakens or diverges significantly from historical patterns, it can impact the strategy’s effectiveness. 

Remember, past performance doesn’t indicate future returns, so it’s important to act accordingly.

Pairs trading example

To understand how pairs trading works, let’s consider an example. 

Imagine you're a pairs trader looking at two tech giants, Company A (CA) and Company B (CB), both publicly listed on the stock exchange. You decide to pairs trade stocks. Here’s how:

1. Correlation analysis

First, you conduct thorough research and find that historically, CA and CB have maintained a strong positive correlation. This means that when CA's stock price goes up, CB's tends to follow suit, and vice versa. You analyze their price movements, financial reports, and market dynamics to confirm this correlation.

2. Divergence

After closely monitoring CA and CB for a while, you notice a temporary divergence in their stock prices. CA's stock has recently surged due to favorable earnings, while CB's stock has lagged due to bearish sentiment. This deviation suggests an opportunity.

3. Pairs trade execution

You decide to execute a pairs trade to capitalize on this mispricing. You simultaneously take two positions:

• Long position in CB: You buy shares of CB, expecting its price to catch up to CA's.

• Short position in CA: You sell short shares of CA, betting its price will revert to its historical correlation with CB.

4. Balanced exposure

To minimize market risk, you ensure your long and short positions are of equal value. This way, you're less exposed to broader movements, focusing on the relative performance of CA and CB.

5. Monitoring and exit

You continue to monitor the performance of CA and CB. As the mispricing corrects itself, CA's stock price starts to decline while CB's rises. When you believe the correlation is nearing its historical norm, you exit both positions, locking in profits from the trade.

This example demonstrates how to identify opportunities based on correlations, execute balanced positions, and profit from the convergence of prices between two related assets. 

Remember, Composer's tools and symphonies can streamline this process, making it easier for traders to implement pairs trading strategies effectively.

How to build a pairs trading strategy

Developing a successful pairs trading strategy involves a series of methodical steps designed to identify potential pairs, assess their historical relationship, and execute trades based on calculated divergence. This approach requires a blend of analytical skills, market understanding, and disciplined trading practices. Here are key steps to build an effective pairs trading strategy:

1. Identify correlated pairs

Begin by conducting statistical analysis to identify pairs of assets that exhibit a historical correlation, like calculating correlation coefficients to quantify the relationship’s strength and direction. Consider fundamental factors that might explain the correlation between assets. 

For example, if you trade stocks, look for companies in the same industry or sector that are influenced by similar macroeconomic variables.

2. Leverage technical analysis

Use technical indicators like moving averages, relative strength index (RSI), or Bollinger Bands to identify pairs with consistent price relationships. Chart patterns and trends can also be valuable.

3. Establish entry and exit criteria

Define specific entry and exit criteria based on statistical deviations from the historical correlation. For example, you may enter a trade when the price spread between the two assets reaches a certain standard deviation from the mean.

Consider using spread analysis, which involves tracking the price differential between the two assets. You might enter a trade when the spread widens beyond a predetermined threshold and exit when it narrows. 

Finally, factor in market volatility––enter pairs trades during periods of heightened volatility when price spreads are more likely to deviate significantly.

4. Manage risk

Determine the size of your positions carefully. It's crucial to balance your long and short positions so they’re of equal or near-equal value. This ensures you're not overly exposed to broader market movements.

Implement stop-loss orders to limit potential losses in case the correlation breaks down or unexpected market events occur. Similarly, set take-profit levels to lock in profits when the price spread converges.

And avoid overconcentration in a single pair or sector. Diversify your pairs trading portfolio to reduce unsystematic risk. Leverage Composer's AI-powered tools to optimize your portfolio for pairs trading strategies.

5. Continuously monitor your pairs’ performance

As pairs trading demands constant vigilance, continuously monitor the performance of your pairs and be prepared to exit positions if the correlation weakens or market conditions change.

Seize trading opportunities with Composer

Building a pairs trading strategy involves quantitative analysis, risk management, and continuous monitoring. That’s where Composer comes in. Our suite of tools can assist, making it a valuable resource for pairs traders looking to streamline their strategy development process.

Don't miss out on profitable pairs trading opportunities. Supercharge your strategy with Composer, and sign up for a free 14-day trial today.