What Is a Pairs Trade?

A pairs trade is a trading strategy that involves matching a long position with a 澳洲幸运5官方开奖结果体彩网:short position in two stocks with a high correlation.

Understanding Pairs Trade

Pairs trading was first introduced in the mid-1980s by a group of technical analyst researchers that were employed by Morgan Stanley, the multinational investment bank and financial services company. The pairs trade strategy uses statistical and 澳洲幸运5官方开奖结果体彩网:technical analysis to seek out potential market-neutral profits.

澳洲幸运5官方开奖结果体彩网:Market-neutral strategies are a key aspect of a pairs trade transaction. Market-neutral strategies involve long and short positions in two different securities with a positive 澳洲幸运5官方开奖结果体彩网:correlation. The two offsetting positi🎐ons form the basis for a hedging strategy that seeks to benefit from either a positive or negative trend.

A pairs trade strategy is based on the historical correlation of two securities. The securities in a pairs trade must have a high positive correlation, which is the primary driver behind the strategy’s profits. A pairs t🍷rade strategy is best deployed when a trader identifies a correlation discr💃epancy. Relying on the historical notion that the two securities will maintain a specified correlation, the pairs trade can be deployed when this correlation falters.

When pairs from the trade eventually deviate—as long as an investor is using a pairs trade strategy—they would seek to take a dollar matched the long position in the 澳洲幸运5官方开奖结果体彩网:underperforming security🌊 and sell short the outperforming security. If the securities return to their historical correlation, a profit is made from the convergence of the prices.

Advantages and Disadvantages of Pairs Trade 

When a pairs trade performs as expected, the investor profits; the investor is also able to mitigate potential losses that would have occurred in the process. Profits are generated when the underperforming security regains value, and the 澳洲幸运5官方开奖结果体彩网:outperforming security’s price deflates. T✨he net profit is the total gained from the two posit💟ions.

𝔉 There are several limitations for pairs trading. One is that the pairs trade relies on a high statistical correlation between two securities. Most pairs trades will require a correlation of 0.80, which can be challenging to identify. Second, while historical trends can be accurate, past prices are not always indicative of future trends. Requiring only a correlation of 0.80 can also decrease the likelihood of the expected outcome.

Example of Pairs Trade

To illustrate the potential profit of the pairs trade strategy, consider Stock A and Stock B, which have 𝄹a high correlation of 0.95. The two stocks deviate from their historical trending correlation in the short-term, with a correlation of 0.50.

The arbitrage trader steps in to take a dollar matched the long position on underperforming Stock A and a short position on outperforming Stock B. The stocks converge and return to their 0.95 correlation over time. The trader profits from a long position and closed 澳洲幸运5官方开奖结果体彩网:short position.