Pairs Trade

What Is a Pairs Trade?

A pairs trade is a trading strategy that includes matching a long position with a short position in two stocks with a high correlation.

Understanding Pairs Trade

Pairs trading was first presented during the 1980s by a group of technical analyst specialists that were employed by Morgan Stanley, the multinational investment bank and financial services company. The pairs trade strategy utilizes statistical and technical analysis to search out potential market-neutral profits.

Market-neutral strategies are a key part of a pairs trade transaction. Market-neutral strategies include long and short positions in two distinct securities with a positive correlation. The two offsetting positions form the basis for a hedging strategy that looks to benefit from either a positive or negative trend.

A pairs trade strategy depends on the historical correlation of two securities. The securities in a pairs trade must have a high positive correlation, which is the primary driver behind the strategy's profits. A pairs trade strategy is best conveyed when a trader recognizes a correlation inconsistency. Depending on the historical thought that the two securities will keep a predefined correlation, the pairs trade can be conveyed when this correlation vacillates.

At the point when pairs from the trade at last veer off — up to an investor is utilizing a pairs trade strategy — they would look to take a dollar matched the long position in the underperforming security and sell short the outperforming security. On the off chance that the securities return to their historical correlation, a profit is produced using the convergence of the prices.

Benefits and Disadvantages of Pairs Trade

At the point when a pairs trade performs true to form, the investor profits; the investor is likewise able to relieve potential losses that would have happened simultaneously. Profits are created while the underperforming security recaptures value, and the outperforming security's price flattens. The net profit is the total acquired from the two positions.

There are several limitations for pairs trading. One is that the pairs trade depends on a high statistical correlation between two securities. Most pairs trades will require a correlation of 0.80, which can be trying to distinguish. Second, while historical trends can be accurate, past prices are not generally indicative of future trends. Requiring just a correlation of 0.80 can likewise diminish the probability of the expected outcome.

Illustration of Pairs Trade

To represent the expected profit of the pairs trade strategy, look at Stock As an and Stock B, which have a high correlation of 0.95. The two stocks veer off from their historical trending correlation in the short-term, with a correlation of 0.50.

The arbitrage trader steps in to take a dollar matched the long position on underperforming Stock An and a short position on outperforming Stock B. The stocks meet and return to their 0.95 correlation over the long haul. The trader profits from a long position and closed short position.

Highlights

• A pairs trade strategy depends on the historical correlation of two securities; the securities in a pairs trade must have a high positive correlation, which is the primary driver behind the strategy's profits.
• A pairs trade is a trading strategy that includes matching a long position with a short position in two stocks with a high correlation.
• Pairs trading was first presented during the 1980s by a group of technical analyst specialists.