Pair Trading

Pair Trading is a market-neutral trading strategy that involves matching a long position with a short position in two correlated assets to exploit relative price movements between them.

Understanding Pair Trading

Pair trading is based on the concept of statistical arbitrage, which seeks to identify relationships between two securities. This technique allows traders to take advantage of pricing discrepancies while minimizing risks associated with market movements.

Key Characteristics of Pair Trading

• Market Neutrality: Pair trades aim to minimize exposure to market risk by investing in two correlated stocks.
• Correlation: The two assets must be historically correlated to ensure that they move in tandem.
• Mean Reversion: The strategy is predicated on the idea that the price relationship will revert to the mean or historical average.

How Pair Trading Works

1. Identify a Pair: Traders identify two stocks that have a historical correlation (e.g., Coca-Cola and Pepsi).
2. Set the Ratio: Determine the price ratio of the two assets at a historical mean.
3. Monitor Divergence: Watch for situations when the prices diverge significantly from their historical ratio.
4. Execute Trades: When a divergence is observed, the trader goes long on the undervalued asset and shorts the overvalued asset.
5. Take Profit: The position is closed when the prices converge again, realizing a profit.

Example of Pair Trading

Let’s consider two tech stocks: Company A and Company B. Historically, their price ratio has been around 1:1.

– Current Prices:
– Company A: $100
– Company B: $90

The ratio is 100/90 = 1.11, indicating that Company A is relatively overvalued compared to Company B.

Pair Trading Execution

1. Short Company A: Sell 10 shares of Company A at $100.
2. Long Company B: Buy 10 shares of Company B at $90.

Calculating Potential Profit

Assuming that after some time, the prices converge back to the historical average:

– New Prices:
– Company A: $95
– Company B: $95

Calculating the results:

– Short Position on Company A:

• Sell Price: $100
• Cover Price: $95
• Profit from Shorting Company A: (100 – 95) * 10 = $5 * 10 = $50

– Long Position on Company B:

• Buy Price: $90
• Sell Price: $95
• Profit from Buying Company B: (95 – 90) * 10 = $5 * 10 = $50

Total Profit Calculation

Adding both profits together:

– Total Profit = $50 (from Company A) + $50 (from Company B) = $100

In this example, the trader successfully executed a pair trade, profiting from the relative price changes of the two correlated stocks. Pair trading can be a valuable strategy for traders looking to capitalize on market inefficiencies while managing their risk exposure.