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Pairs Trading

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Definition of Pairs Trading

Pairs trading can be defined as a trading strategy that uses both statistical and technical analysis and consists of combining long and short positions in highly correlated stocks in order to achieve profit rates higher regardless of which direction the market is moving. This strategy is not affected by the direction of the market. This type of strategic option trading is a combination of long and short positions in related stocks. It is a market-neutral strategy, based not only on statistical but also technical analysis, with the sole purpose of generating potential returns of a market-neutral nature.

How does pair trading work?

The Paris trading strategy assumes that there is neutrality in the market, or in other words, both stocks will move and continue to move the same as before. This means that traders participating in this strategy will be looking for high-correlation stocks.

These values ​​may belong to a sector, and sometimes even to direct competitors. These highly correlated actions may begin to diverge in their respective price movements and may occur for minutes, weeks, or even months in the long run.

Pair traders in a market-neutral concept expect the price of stocks that are currently not doing well to recover, or in other words, they expect the price of their underperforming stocks rises. Torque traders in a concept of market neutrality also expect the price of securities that are overweight to fall in the hour approach

Pair Trading Strategy

The historical correlation ​of the two stocks is the basis of a pair trading strategy. The main driver of this strategy could be the fact that the stocks participating in it should necessarily have a higher positive correlation rate

​If a trader detects a correlation deviation, he may choose to implement this strategy. In other words, when a trader realizes that the two stocks are unrelated or if the correlation between the stocks no longer exists, then he or she can implement pair trading. Traders can even get rid of the short stock by selling it for as its prices are expected to go down, while they can hold on to the long stock as its prices are expected to rise.

Difference between pair trading and statistical arbitrage

​Statistical arbitrage can be defined as a modified version of a pair trading strategy. Statistical arbitrage includes such trading strategies which are quantitatively driven. The ultimate goal of any strategy is to produce a higher rate of profit for the trading companies.

​Statistical arbitrage is a medium-frequency strategy, not a high-frequency strategy. Statistical arbitrage is mainly applied in financial markets and has become very popular in hedge funds and investment banks. Unlike pair trading, statistical arbitrage is not limited to two stocks or stocks. Traders can apply the concept of statistical arbitrage to a variety of related stocks. Statistical arbitrage uses large and diversified portfolios that only trade over a shorter period

Advantages

Helps mitigate risk: It can help mitigate risk as it deals with trading two stocks which means that even if one is underperforming the other can absorb losses. Helps to minimize business risks arising from movements in the direction of the market.

Guaranteed Profits – Ensures that the trader makes a profit regardless of market conditions. In other words, pair traders will be able to earn returns on trading, whether the market swings sideways, loses, wins, etc.

Disadvantages

Price filling: Profit generation in pair trading relies on too tight margins and trades need to be executed in large volumes, which indicates that there is a high risk that stock orders will fail. are not executed at an expected price.

Commissions: Pair trading is strongly discouraged by some traders as it requires them to pay a higher commission. Sometimes a single trading pair can require the trader to pay double the commission for a standard trade. For traders who trade with tight margins, the commission difference would be the difference between gains and losses.

Conclusion

In a concept of pair trading, regardless of how the market moves, linked stocks will continue to move in the direction they were already moving. In the case of a long trade, the price of the underperforming linked share will increase while, in the case of a short trade, the price of the outperforming linked share will fall.

To conclude, it can be said that pair trading is one of the powerful tools of trading as it can help to mitigate or minimize the risks associated with trading and even allow traders to make profits regardless of the real market development. can also fail if the correlation between stocks is not assessed correctly.

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