Pair trading is a term that refers to a market-neutral trading strategy, where a long position is taken in one financial instrument (like a stock) and a short position in another financial instrument that is positively correlated with it. The goal is to profit from the price differences between the two financial instruments, believing that the spread between them will revert to historical correlation levels.
Broader interpretation:
Market-neutral:
Pair trading does not anticipate a rise or fall in the market in general, but relies on the relationship between two financial instruments.
Positive correlation:
It means that the two financial instruments move in the same direction, i.e., they rise or fall together.
Long position:
It means buying the financial instrument and anticipating an increase in its price.
Short position:
It means selling the financial instrument (by lending it) and anticipating a decrease in its price.
Price differentials:
It is believed that the two financial instruments will return to their natural correlation level, meaning the spread between them will decrease.
Relative value arbitrage:
Pair trading is a type of arbitrage that takes advantage of price differences between related assets.
How is pair trading done?
1. Identifying the pair:
Two financial instruments with a high correlation are selected, such as two stocks in the same sector or two similar funds.
2. Correlation analysis:
The historical level of the increase or decrease of the two financial instruments is determined.
3. Defining exit from the range:
The time when the difference between the two financial instruments becomes significantly larger than the historical level is determined.
4. Opening positions:
A long position is taken in the financial instrument that is considered undervalued and a short position in the financial instrument that is considered overvalued.
5. Profit:
Profit is achieved when the spread between the two financial instruments returns to the historical level.
Examples:
Pair trading can be used with stocks, where the trader can take a long position in one stock and a short position in another stock in the same sector.
Pair trading can also be used with cryptocurrencies, where the trader can take a long position in one digital currency and a short position in another digital currency.
Note: Pair trading requires expertise in technical and financial analysis, and the trader should be familiar with the markets they are trading in.