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Pairs trading is a swing trading strategy which tries to generate profits based on low risk trades. Long-short trading is another name for pairs trading because each trade consists of a related long and short position. These two positions can both be shares or a share and an index (market or sector). Nearly all institutional investors engage in pairs trading. Hedge funds always have a pairs trading fund in their product range.
Pairs trading tries to detect two instruments whose market price tends to evolve in tandem. These instruments are correlated. When, at one point in time, their prices no longer move in tandem (one goes up the other goes down, or one goes up a lot and the other just a little) traders assume the diversion is only temporary. The probability is high that the instruments return to their usual relationship and will start to move in tandem again. When diversion occurs traders will short sell the strongest performer and buy the weakest performer.
A pair trade is based on the price relationship between two correlated instruments. The evolution of the market is of secondary importance. For this reason some investors call it market neutral trading.
The strategy in detail
Institutional investors have many sophisticated ways via which interesting pairs can be detected (e.g. betas and other correlation data). This data mining is less accessible to the retail investor. However, by applying some common sense and a few tools the retail investor can already get very far. Logic dictates that there are categories of instruments in which correlated pairs appear more frequently. These categories are: shares operating in the same sector (e.g. two car manufacturers) and, a share versus its sector or market index. Our trading platform contains tools for pairs trading.
Attention: It is crucial when pairs trading that both the open positions have the same size in money terms. If one position has a value of, say, £ 10.000 the other position’s value must be as close as possible to this amount. It is possible to work with shares which quote in different currencies. In this case you need to take into account the exchange rate to calculate each position’s size. Keep in mind that if you work with positions in different currencies changes in exchange rates can also influence your trade’s net result.
Our advanced Nanotrader Full platform contains a very practical tool called compound symbols. This tool allows traders to plot the relative performance of a pair in real-time. The trader can draw horizontal trend channels directly on the chart and set alarms at the break-out levels.
Pairs trading has a guaranteed place in the arsenal of most institutional investors given its potential for profits with low risk trades. Based on this, it is a technique worth mastering for the retail investor. A pair trade consists of two related positions, one long and one short. Profit or loss are a consequence of their relative price movements. The movement of the overall market is less relevant. The trading platform contain beautiful, free tools for the pairs trader.