Pairs trading is a market-neutral arbitrage strategy that always involves taking two opposite positions in correlated securities. The underlying idea guiding traders who pursue this strategy is to buy one asset and short another to capture price discrepancies occurring either during a trending market or during economic consolidation. This sort of trading involves buying security while selling another short to profit from relative price movement.
Mechanism of Pairs Trading
Pair trades exploit a historical correlation between two securities, typically having a correlation coefficient equal to or greater than 0.80. When these securities’ prices diverge from their historical relationship, traders take advantage of the discrepancy. In a case when Stocks A and B are usually correlated but now diverging, the trader will go long on Stock A (underperforming) and short on Stock B (outperforming) in anticipation of a convergence in their prices back to the historical correlation.
Advantages of Pairs Trading
- Market Neutrality: This strategy fosters risk mitigation from market volatility so traders can profit in any market direction—up, down, or sideways.
- Diversification: Investments through pair trades would diversify portfolios while reducing individual stock-related risks.
- Profit Potential: When pairs trading is correctly pursued, it can yield tremendous profits, as the prices of the two securities will return to their historical correlation.
Disadvantages of Pairs Trading
Pair trading has many limitations. Because of the strong statistical correlation between the two securities, it is challenging to identify decent pairs. Even though historical correlations can give us good insights, they cannot guarantee probable future performance. Furthermore, smaller opportunities limit profitability, as traders are expected to act quickly to exploit these discrepancies.
Therefore, pairs trading remains an advanced technique that necessitates skilful application and thorough market analysis for it to be profitable.