Introduction
Market researchers who utilize quantitative analysis to generate lucrative trading techniques are referred to as "quants" on Wall Street. In summary, a quant looks for profitable trading opportunities by analyzing price ratios and statistical correlations between companies or trading vehicles.
During the 1980s, a group of Morgan Stanley quants hit gold with a strategy known as the pairs trade. Since then, institutional investors and proprietary trading desks at big investment banks have started employing the strategy, and many have profited handsomely.
Because it is rarely in the best interests of investment bankers and mutual fund managers to discuss winning trading tactics with the general public, the pairs trading remained a trader's secret until the internet.
Online trading provided novices with access to real-time financial data and a variety of investment ideas. Individual investors and small-time traders trying to mitigate their risk exposure to market changes quickly became interested in the pairs trading.
What Is Pairs Trading?
Pairs trading allows you to make money by placing easy, low-risk wagers. The pairs trade is market-neutral, meaning that the direction of the broader market has no impact on whether it wins or loses.
The goal is to match two highly linked trading vehicles, one long and the other short, when the pair's price ratio diverges "x" number of standard deviations—"x" is optimized using historical data. One or both positions gain if the pair reverts to its mean trend.
How Does Crypto Pairs Trading Work?
You can compare the prices of multiple cryptocurrencies using cryptocurrency pairs. These conversions show how much BTC and ETH are worth in terms of other crypto assets, such as how much BTC is worth in BCH.
Exchanges typically provide many pairing options, allowing you to select a pairing depending on the currencies you already own. If you hold BTC, for example, you can trade it with any pairing listed on an exchange that accepts BTC.
Most exchanges provide btc/eth pair trading, which are the most versatile cryptocurrency combinations to trade. While many crypto exchanges allow cryptocurrency and fiat currency pairings, such as BTC to the US dollar (USD), others do not.
Using Stocks as an Example of a Pairs Trading
Traders can build a pairs trading technique using either fundamental or technical data. Although our example is technical in nature, other traders assess correlation and divergence using a P/E ratio or other fundamental criteria.
Finding two highly correlated equities is the first stage in creating a pairs trade. Usually, this means the companies are in the same industry or sub-sector, but this isn't always the case.
Index-tracking equities, such as the QQQQ (Nasdaq 100) or the SPY (S&P 500), for example, can provide good pairs trading chances. The S&P 500 and the Dow Jones Utilities Average are two indices that tend to trade together. The correlation between the two indices can be seen in this basic price plot:
We'll use GM and Ford as an example because their companies are heavily connected. Because they are both American automakers, their stocks tend to move in lockstep.
An Example With Futures Contracts
Pairs trading is a method that can be used with stocks, currencies, commodities, and options. Smaller investors can trade futures using "mini" contracts, which are smaller contracts that reflect a fraction of the full-size position's value.
Arbitrage linking the futures contract and the cash position of a certain index may be involved in a pairs transaction in the futures market. When the futures contract outperforms the cash position, a trader may try to benefit by shorting the future and going long in the index tracking stock, anticipating that the two would eventually converge.
The margins between an index or commodity and its futures contract are frequently so thin that profits are reserved for the most nimble of traders — often employing computers to execute massive trades in the blink of an eye.
An Example With Options
Calls and puts are used by option traders to hedge risks and profit from volatility (or the lack thereof). A call is an agreement by the writer to sell shares of a stock at a specified price at a future date. A put is a promise by the writer to buy shares at a specific price at a future date.
Making a call for a security that is outperforming its pair and matching the position by writing a put for the pair is an example of a pairs trading in the options market (the underperforming security).
The options become worthless as the two underlying positions revert to their mean, allowing the trader to pocket the profits from one or both of the positions.
Evidence of Profitability
William Goetzmann, Even G. Gatev and K. Geert Rouwenhorst of Yale Business School attempted to prove the profitability of pairs trading in a significant research study.
The three discovered that the pairs trade averaged a +12% return over any six-month trading period using a vast set of data from 1967 to 1997.
Their test comprised conservative estimates of transaction costs and randomly selected couples to separate lucrative findings from pure luck.
Recent study has also shown that pairs trading can still be profitable, despite the fact that algorithmic and high-frequency trading (HFT) has largely confined this market to experts.
Conclusion
The market is jam-packed with ups and downs that force weak players out and perplex even the most astute forecasters.
Fortunately, investors and traders can earn in any market environment by employing market-neutral tactics such as the pairs trading.
The simplicity of the pairs trading is its appeal. A portfolio caught in the rough waves of the overall market can use the long/short connection of two linked securities as a ballast.
Best of luck in your quest for profit in pairs trading, and here's to your market success.