What Is Pairs Trading?

Hence, we regress the stock prices to calculate the hedge ratio. After a selection process has been defined, a trader must use that process to generate a list of candidate trades. If relying on manual research, the results of this inquiry constitute the list; if relying on a model, the model’s output serves as the list of candidates. Another way to do this is to run a “pairs” trading strategy that consists of more than 2 assets per strategy.

You don’t need your pairs trade to return huge profits per trade. After a few trades, zm stock price quote and news you can have a feel for the average divergences and convergences, i.e. deviations. If you see that divergences and convergences keep occurring, your strategy might have potential. If so, you can then consider moving on to actual backtesting with code. This high degree of correlation, suggesting that one stock will always (eventually) catch up with the other, is at the heart of a strategy called pairs trading. As a general rule when the stock ratio reaches the upper BB or 2 standard deviations, you can sell Tesla and Buy GM.

Evidence of Profitability

To measure these relationships, the pairs trader metatrader 4 white label trading platform will use statistics, fundamentals, technical analysis, and even probabilities. One of the main keys to pairs trading is finding strong correlations between financial instruments, thus building a foundation for further analysis. The empirical data are then dissected to unearth information that allows the trader an efficient and methodical way of executing successful trades.

The pairs trade strategy uses statistical and technical analysis to seek out potential market-neutral profits. Pairs trading can generate profits in both bullish and bearish market conditions. By taking positions in both long and short sides of the trade, you can capture profits regardless of the overall market direction. This flexibility sets pairs trading apart from other traditional strategies that rely on market trends.

Correlation coefficent

If you find potential in your visual test, you can then move on to testing the strategy using code. This article is intended for educational purposes only and not as an endorsement of a particular financial strategy, company, or fund. And if your brokerage platform has a trade simulator (where you can practice with pretend money), start there.

This high number represents a strong relationship between the two stocks. Pairs traders use some type of analysis methodology to confirm the trade and help customize the buy and sell rules. An overlay analysis will help adjust profit objectives and stop loss levels according to the specifics of a given trade. There are many different types of technical and fundamental overlays that can be employed, from candlestick charting to relative strength.

In order to mitigate the risk of being wrong, Joe decides to pair his trade with another sector-related stock. On the other hand, for two inversely correlated currency pairs, you could place trades in the same direction. Ideally, when you place a similar trade between two closely correlated pairs, it means that you will make money when the two move in the predicted direction. On the other hand, if the price moves in the opposite direction, you will make a bigger loss. Finally, the other simple way of identifying correlated or uncorrelated assets is to use the freely-available resources.

Price Filling

1. When prices de-correlate (red circles and boxes), notice how the price spread between KO and PEP widens.
2. The difficulty comes when prices of the two securities begin to drift apart, i.e. the spread begins to trend instead of reverting to the original mean.
3. A perfect positive correlation is when one variable moves in either an upward or downward direction and the other variable also moves in the same direction with the same magnitude.
4. If you are a $10 billion quant hedge fund, then yes, you have the resources to collect plenty of data.
5. For futures, the dollar value per unit of movement is usually different for different future contracts.

Let’s assume that we have put at work $10,000 for each of the two stocks. In this case scenario, we would have bought 28 shares of TSLA ($10,000/$350) and sell 270 shares of GM ($10,000/$37). We use the Bollinger Bands indicator to spot the times when the correlation between the two stocks has moved too far from the norm, which will result in a trading opportunity.

Keep doing this and record the profits and losses of your hypothetical trades. When one stock moves up or down, the other tends to follow suit. One stock may significantly jump ahead or fall behind the other (i.e., fall out of correlation), but such anomalies have, historically, turned out to be short-term blips. With the first approach, you would have short-sell TSLA on August 2 at $350 a share. Once we make sure the stock price doesn’t move in tandem anymore, then a trade can be taken right away when the stock ratio touches the upper Bollinger Bands. In the chart below, we have identified an instance where Tesla’s stock price rallied sharply in value relative to GM stock price.

Decorrelation: The big pairs trading risk (and opportunity)

It is a concept that is popular across asset classes like stocks, exchange-traded funds (ETFs), and commodities. For example, in most cases, when the DAX index rises, it increases the possibility that the FTSE 100 or the CAC 40 indices will rise as well. Similarly, unless there are major events, when Chevron shares rise, there is a possibility that ExxonMobil will also rise.

These programs are designed to simultaneously work each side for the trader, particularly for larger orders, in an attempt to hit a pre-specified price ratio. For most traders, such programs are more of a convenience than a necessity because the slippage that occurs during execution is minimal relative to the profit objective of the overall trade. But sometimes, two historically correlated stocks diverge and stay that way, due, perhaps, to a permanent fundamental change in one of the two companies.

Mean and standard deviation can be rolling statistics for a period of ‘t’ days or minutes or time intervals. ​​The 9 best stock advisor websites 2020 most common test for Pairs Trading is the cointegration test. Cointegration is a statistical property of two or more time-series variables which indicates if a linear combination of the variables is stationary. Now, both ‘a’ and ‘b’ increase in such a way that the value of the spread decreases.

However, when the stock ratio touches the lower BB or 2 standard deviations, you should buy Tesla and sell GM. In the chart below we can see that General Motors and Tesla often move in tandem. When the correlation stops, then we’re presented with a trading opportunity to short-sell General Motors when it’s outperforming and go long Tesla when it’s underperforming.

You have now overlaid the chart of Z (blue) on the chart of EWU (red). As a stitched together chart of all the most actively traded contracts. I don’t recommend you run this strategy live unless you understand it very well.

The first and foremost step of creating a pairs trading strategy is the co-integration of the pair. Once the pair of stocks is co-integrated, they can be considered for the pairs trading strategy. For finding out the co-integration, Augmented-Dickey Fuller Test is used. 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 trade strategy is best deployed when a trader identifies a correlation discrepancy.