Pairs trading is a strategy which enables traders to profit from virtually any market conditions; uptrend, downtrend or sideways movement. The pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss.
Pairs trading works by monitoring the performance of two historically correlated securities, buying one stock and at the same time, short selling another correlated stock – then exiting the pair trade once the relationship between the two stocks has returned to its average. The divergence within a pair can be caused by temporary supply/demand changes, large buy/sell orders for one security or a reaction to important news about one of the companies for example. It has been a widely used trading system by professional traders and hedge funds all around the world for decades and its appeal is that it has the potential to achieve profits through simple and relatively low-risk positions.
When using a pairs trading system, you have to ensure you are trading two similar stocks. Coke/Pepsi is an example of a correlated pair. They are two very similar companies in that they both operate in the same markets and sell the same products; non-alcoholic beverages. As they are both exposed to the same macro-economic and industry conditions, their stock prices are priced with similar valuations by the market. Ebay/Amazon, commodities like Gold/Silver and Indices such as Dow Jones/FTSE are further examples of correlated pairs. You should always make sure your trading platform tells you the correlation between the two similar stocks is above 70% with really good pairs above 90% correlation.
If the pairs diverge away from each other, this represents a pairs trading opportunity to make money, so you would buy the asset that has gone down, short sell the asset that has gone up, and exit once the relationship between the two correlated stocks returns to normal. This is also known as reversion to the mean, statistical arbitrage, market neutral or long/short trading. By always having an equal amount of your account in long and short positions, this will keep your portfolio market neutral. In this way, you are not exposed to large one way market swings as you are betting on the relationship between two correlated pairs, not on the outright direction of the market. This significantly reduces your risk and allows you to safely increase your trading leverage.
The pairs trading strategy works with stocks as well as with currencies, commodities and binary options. Binary options traders use calls and puts to hedge risks and exploit volatility. A pairs trade in the binary options market might involve trading a call for an asset that is outperforming its pair and matching the position by trading a put for the pair. As the two underlying positions revert to their mean again, the options become worthless allowing the trader to pocket the proceeds from one or both of the positions.
Pairs trading has proved to be a very effective method for consistent profits. It has also increased in popularity mainly due to the advent of the internet and advancements in trading technology. This means that market participants now have access to real-time financial market data and advanced computer modeling. As there are 1000s of stock pairs out there to trade, it is impossible to calculate all of the correlations manually so you need to access a pairs trading platform like Banc De Binary in order to find the right pairs, which in turn will allow you to embark on a profitable pairs trading strategy.