Pair Trading was once called a holy grail of Wall Street. The trading strategy was kept under the wraps for so many years; and in the meantime, profited many small companies to turn into big empires, including Morgan Stanley.
The popularity of Pair Trades strategy quickly gained traction among various hedge funds, insurance companies and large banking institutions. With the arrival of internet, the strategy became more accessible to people and is now widely implemented in stocks, indexes, futures, options, as well as forex trading.
What is Pairs Trading?
Pairs Trading is a less-risky, more neutral market trading strategy which is based on the phenomenon of two historically correlated securities. For instance: the stocks of soft drink giants Coca Cola and Pepsi are two potentially correlated pairs, which have generally dipped and surged almost identically. However, there are also times when demand of Coca Cola rises, influencing its stock value to discontinue mimicking the Pepsi stock. This temporary shift brings out an opportunity for trades to sell the Coca Cola stock and buy the Pepsi one, assuming that both the stocks will correct themselves to reform the good-old balance.
Therefore we can state: Pairs Trading is a phenomenon that enables traders to earn profit from correlated market pairs, while ensuring low risk positions. The pairs trading is also a “market-neutral” strategy as it enables traders to make profit from all sort of marketing conditions: uptrend, downtrend or sideways.
Constructing a Pair Trade
The first and the foremost requirement for executing a pair trading strategy is to find potentially correlated trading pairs. To start: one can always look into companies belonging to the same industry or sub-sector through a special indicator. This is a purely technical approach which requires traders to do some index tracking.
PCI GeWorko Method
The online Forex and CFD trading company IFC Markets that has recently introduced an innovative approach to study one financial asset relative to another, irrespective of their backgrounds. It is the Personal Composite Instrument (PCI) technology, based on GeWorko Method, which allows traders to compose trading instruments of their own choice.
For instance – new cross currency pairs, as well as currency against commodities, stocks against stock indices, and many other trading instruments can be created by applying this technology.
While we put this method in the framework of pair trading, it seems like a natural fit. With it, traders can independently create a chart between two different instruments (portfolios) with possible pair trade correlations. They can also examine the behavior of the created instruments separately and in relation to each other based on a long-term historical data of instruments. What’s further attractive – IFC Markets allows clients to see the created instruments reflected in US Dollars regardless the financial sector, to which the component financial assets belong.
PCI GeWorko truly emerges as an innovative and handy tool for traders wishing to execute pairs trade strategy. It allows them to bring up endless number of financial instruments. In addition to this, traders can also analyze their charts with a range of analytical tools available within the service. Totally recommended!!!
How to Pair Trade?
While watching these charts, a trader is always required to take note of imbalanced price actions. When they occur, make sure to make a long trade on the bearish stock and a short one on the bullish one. The revenue generated from the short position can support the costing requirements of the long position, making the trade less risky and decently profitable at the same time.
Nevertheless, make sure to place your stop losses points before starting to trade. A less risk is still a risk after all.
Other Markets to Look for
In addition to stock markets, a Pair Trading strategy can also be applied in currency, commodity and options trade. Small investors can be hopeful of applying it in the future markets by creating an arbitrage with the cash position on a given index.
As usual, for a small investor to make a decent return, he would have to wait for future contract to move above the cash position. In this case, he can short can earn profit by shorting the future position and placing a long trade on index tracking stock. Traders however need to act fast on these trades.
The market is full of surprises — good and bad. Pairs Trading just offers one an opportunity to stay safe and lucky during choppy periods. Unlike others, it is a very simply strategy to implement, something which can be learnt even by novices. We wish you good luck while you execute it on your trades. Have a successful trade!