As with nearly any investment, taking a pairs trade involves more than just hitting the buy and sell button. Here we examine, in very broad terms, the steps required to enter and exit a pairs trade. Assemble a list of potentially related pairs Just as long-only stock traders scan the markets for suitable securities, a pairs trader must start with a list of potentially related pairs. This entails conducting research to find securities that have something in common — whether the relationship is due examples sector such as the auto sector or to asset for example, bonds.
While any random pair could theoretically be correlated, it is more likely that we will find correlation in securities that have something in common to begin with. Determining the correlation level The next step acts as a filter, or a means by which we can reduce the number of potential pairs in our quiver.
One way is to use a correlation coefficient to determine how closely two instruments are related. Below the price chart is an indicator pair shows the correlation coefficient in yellow. We can see from the chart that during the time period evaluated, the ES and YM are highly correlated, with values examples around 0.
Visual confirmation of price, backed by quantitative results from the correlation coefficient in yellowshow that the two instruments are highly correlated. Image created with TradeStation. Trading chart, shown in Figure 5, illustrates a pair that is not correlated. Here, the correlation coefficient in yellow demonstrates that the relationship is scattered, ranging from high values of about 0.
Figure 5 This daily chart of WMT in red and TGT in green shows that this is not an ideal pair at least not during the time period tested. A visual review of prices, confirmed by results from the correlation coefficient in yellow indicate a lack of correlation between the two stocks. Use modeling to determine specific rules An ongoing component of the trading is to research and test trading ideas and determine absolute methods of evaluating pairs and defining divergence.
In general, traders should focus on quantifiable data: The mean appears in pink. Figure 6 A daily chart of the ETFs SPY in red and DIA in green. A spread ratio indicator appears below the price chart, along with a standard deviation overlay.
Determining position sizing Many traders use a dollar-neutral approach to position sizing when trading pairs. Using this method, the long and short sides of the trade are entered with equal dollar amounts.
To achieve a dollar-neutral position, the trader will have to purchase two shares of stock B for every one share of stock A. Buy the underperformer and sell the overperformer Once the examples rules are met, the trader will buy the underperforming security and simultaneously sell the overperforming security. Here, a long position is entered with two ES contracts, and a simultaneous short position of two contracts is taken in the YM.
The order entry interface appears on the left side of the screen one order entry box for the ES; pair for the YM. Use sound money management principles to exit the trade As with most investments, the timing of the exit is critical to the success of the trade. It is important to apply money management principles to pairs trades, including the use of protective stop-loss orders and profit targets. Optimal levels are typically determined through extensive historical modeling.
Despite exhaustive research, modeling and testing, a pairs trading strategy may fail to live up to expectations. Two risks that traders have are model risk and execution risk, introduced in the next section. Dictionary Term Of The Day. A legal agreement created by the courts between two parties who did not have a previous Latest Videos PeerStreet Offers New Way to Bet on Housing New to Buying Bitcoin? This Mistake Could Cost You Guides Stock Basics Economics Basics Options Basics Exam Prep Series 7 Exam CFA Level 1 Series 65 Exam.
Sophisticated content for strategies advisors around investment strategies, industry trends, and advisor education. Pairs Trade Example By Jean Folger Share. Market Neutral Investing Pairs Trading: Correlation Arbitrage and Pairs Trading Fundamental and Technical Analysis for Pairs Trading Pairs Trade Example Pairs Trading: Risks Disadvantages of Pairs Trading Advantages of Pairs Trading Pairs Trading: Knowing the relationships between pairs trading help control risk exposure and maximize profits.
Pairs traders wait for weakness in the correlation, and then go long on the under-performer while simultaneously going short on the over-performer, closing the positions as the relationship returns If you are following a range-trading strategy, you're better off with strategies that do not include the U.
When trading in forex, all currencies are quoted in pairs. Find out how to read these pairs and what it means when you buy and sell them. Relationships between currencies and commodities exist throughout the financial markets. Find out how to trade these trends.
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