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Everything you need to know about Pairs Trading.

  • Posted Date: August 26, 2021
Share Trading Tips

We go through various trading strategies to maximize our profits and minimize the risk part of it. We also have to balance these things while managing our portfolio as well. One of the strategies used by most of the traders is Pairs trading. Pairs trading consists of matching a short position with a long position in multiple stocks having a high similarity and pairing them.

Pairs trading is not generally performed by Indian traders but is a very simple strategy in the international share markets. It was originated in the early 1980s by a share market advisor company called Morgan Stanley a by performing optimum Stock market technical research and analysis.

In this blog, we will discuss the advantages and disadvantages of pair trading, and pro share market tips to enhance your portfolio.

What is Pairs Trading?

The basics fundamentals of pairs trading consist of correlation between two stocks. For pairs trading, it is required that the two stocks must have a positive high correlation. This high positive correlation is helpful in getting the profits of pairs trading strategy.
Pairs trading is a market-neutral strategy and requires you to have two positions – long and short in two different high correlation stocks. These two positions are the basis for developing a hedging strategy that intends to obtain profits from a negative or positive trend in the market.
The best time to perform the pairs trading strategy is when there is a correlation deviation in the market. When the trade eventually starts to deviate, you can expect profits from the long position in the underperforming stock and short selling the outperforming stock.

An example of quality pair trading:

It’s getting a bit confusing for you, let us take an example. Assume there are two different stocks X and Y. These stocks are having a high positive correlation value of 0.95. Now, both these stocks start deviating from their previous correlation within a short period of time, with a correlation of 0.35.
Now at this point, traders will step in and take a dollar-matched short position on the outperforming stock Y and a long position on the underperforming stock X. After some time, these stocks converge and return back to their correlation of 0.95. At this point, the trader will book profits from the long position and exit from the short position.

Pros of pair trading:

The first and foremost advantage of performing a pairs trading strategy is that it helps to maximize your profits and also helps in decreasing the potential risk at the same time. Its more over neutral process and while performing it in a right way you can optimize your portfolio and share market earnings. You can do it for a short term gain or intraday marketing as well, keep your eyes wide open and read about share recommendations for the same. The net profit from both of the stock holdings, minus any potential losses will be your total generated profit by doing pairs trading.

Cons of pair trading:

Like every other share tips or market trading strategy, pairs trading also have some risk factor which you should avoid. The most general disadvantage of pairs trading is that it relies on correlation between the stocks. Figuring out these correlation as a beginner in share market is very tricky. You should always consider share trading tips from a reliable source or company. Also the past trends are mostly right but they do not tell anything about future trend situation because anything could happen in the world economy like Covid 19 pandemic.

Summary:

Pairs trading is a successful trading way that attracts to many traders, particularly to those who wants to follow a market-neutral strategy. Just as with any strategy one intimate that the trader should have a trading plan with predefined entry and exit rules and have the order to follow them despite of market conditions.

There are some steps you should keep in mind for a successful pairs trading:

  • Formation of a selection criteria
  • Make a list of candidate trades
  • Implement technical, fundamental, or other statistical overlays
  • Execute the trade timely
  • Manage the trade
  • Close the trade on time

By following the above steps, you can maximise your profits from pairs trading method.

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