Definition
Pairs trading is a strategy used in finance where an investor simultaneously buys a long position in one security and sells short another security. These two securities are typically highly correlated and are usually stocks or commodities. The intention is to profit from a change in the relative prices, betting that the price of the long position will rise and the price of the short position will fall.
Key Takeaways
- Pairs Trading is a market-neutral trading strategy that matches a long position with a short position in a pair of highly correlated instruments such as two stocks, exchange-traded funds (ETFs), currencies, commodities or options.
- This strategy is based on the concept that the prices of the two instruments will maintain the correlation over time and any divergence from the correlation will eventually be corrected. The objective in pairs trading is to profit from this correction.
- Pairs Trading is considered a relatively safe trading strategy that is less exposed to the volatility of the broader markets. However, like all trading strategies, it also carries risk. Investors need to carefully monitor their pairs, as the correlation can break down under certain circumstances, leading to potential losses.”
Importance
Pairs Trading is a crucial strategy in finance because it enables investors to mitigate risk and potentially generate profits regardless of market conditions.
This strategy involves identifying two securities (often in the same industry) whose prices have historically moved together, and betting on the return of the price relationship when a temporary discrepancy occurs.
By simultaneously buying the undervalued security and selling the overvalued one, traders aim to profit from the expected price correction.
Therefore, the importance of pairs trading lies in its ability to provide profit opportunities and diversification while minimizing losses, as it is largely unaffected by the overall market movement and depends on the relative performance of two stocks.
Explanation
Pairs trading, often referred to as a market neutral strategy, serves an important purpose in finance to hedge risk and create a balanced portfolio. Primarily utilized in forex, options, and stock markets, pairs trading is a strategy that involves matching a long position with a short position in two stocks with a high correlation. The main aim of this strategy is to create a market-neutral position to make profits by predicting the relative movements of the two paired stocks.
This technique essentially allows investors to profit from market corrections, where the relationship between the two stocks returns to the mean, regardless of the direction of the overall market. Furthermore, pairs trading is used to take advantage of temporary price inefficiencies. Typically, the two stocks that are picked for pairs trading are in the same industry and have historic price trends that move together.
However, at times, due to a variety of factors, the relative prices of the two stocks could deviate from their historic norm, creating a potential pairs trading opportunity. In these cases, an investor will go long on the underpriced stock and short the overpriced stock. This strategy is ideal for traders looking for arbitrage opportunities and wanting to hedge their risk exposure.
Examples of Pairs Trading
Pairs trading is a strategy that involves buying one financial instrument and simultaneously selling another related financial instrument. It is based on the assumption that the prices of the two instruments will maintain a certain relationship and when this relationship is disrupted, it will ultimately revert. Here are three real-world examples of pairs trading:
**Pepsi and Coca-Cola**: An example of pairs trading could involve two companies in the soda industry, like Pepsi and Coca-Cola. These two companies are bound to share a relationship given that they operate within the same industry and thus face similar market conditions. If Pepsi’s stock outperforms Coca-Cola’s unexpectedly, a pair trader could buy Coca-Cola stock and sell Pepsi stock, betting that the stocks will revert to their historical performance pattern.
**Gold and Silver**: In the commodities market, a trader might look for pairs like gold and silver. These two precious metals often trade in a correlated fashion. If silver prices surge while gold prices stay flat, a trader might sell silver futures contracts and buy gold futures contracts, anticipating the silver-gold ratio to eventually revert to its historical mean.
**Oil Companies: ExxonMobil and Chevron**: Two oil companies such as ExxonMobil and Chevron can be another example. Their stock prices usually move together as they are influenced by similar factors such as oil prices, geopolitical tensions, etc. However, if Chevron’s stock price falls due to, say, a temporary problem in one of its oilfields, a pair trader might sell ExxonMobil stock and buy Chevron stock, expecting Chevron’s stock price to recover and once again follow its pairs trading relationship with ExxonMobil.
FAQs for Pairs Trading
What is Pairs Trading?
Pairs trading is a market-neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. It involves buying one security and shorting a closely related one to hedge against market conditions.
What are the advantages of Pairs Trading?
Pairs Trading has several advantages. Firstly, it is market-neutral, meaning that market conditions do not affect it as much. Secondly, the trades usually involve closely related securities, reducing the risk levels. Lastly, it can provide steady profits if executed correctly.
What are the risks associated with Pairs Trading?
Although Pairs Trading can be less risky than other forms of trading due to its market-neutral status, it’s not without risk. For example, the two securities used could not behave as expected. Also, like any trading strategy, there’s the risk that you could lose your investment.
How can I start with Pairs Trading?
To start with Pairs Trading, you first need to identify two securities that move together. Then, you watch for divergence in their price movement. When one security rises above the other, you short the higher one and go long on the lower one, expecting them to converge again.
Who typically uses Pairs Trading?
Pairs Trading is used by various types of traders, including hedge funds, institutional investors, and individual retail traders. Someone with a strong understanding of the markets and who is looking to mitigate market-related risks typically uses this type of trading.
Related Entrepreneurship Terms
- Arbitrage
- Market Neutral Strategy
- Correlation Coefficient
- Mean Reversion
- Long/Short Position
Sources for More Information
- Investopedia: Investopedia provides a wealth of information on a variety of finance terms including pairs trading.
- Reuters: Reuters is a reputable news agency that often covers finance topics and could potentially provide useful information on pairs trading.
- Bloomberg: Bloomberg offers in-depth financial news and analysis, including articles and insights on a variety of trading strategies like pairs trading.
- Financial Times: The Financial Times serves as a comprehensive resource for global finance news and economic analysis, covering many complex finance topics including pairs trading.
