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Don't worry about market direction again with a pairs trading strategy, where you're long one asset and at the same time short another similar asset.
What is Pairs Trading?
Pairs trading is a type of investment strategy that involves simultaneously buying and selling two related financial instruments in order to profit from their price differential. This can be done with a wide range of financial instruments, including stocks, bonds, commodities, currencies, and derivatives.
The basic idea behind pairs trading is to identify two instruments that are historically correlated and then take advantage of any temporary price discrepancies that may occur. For example, if two stocks in the same industry tend to move in the same direction over time, a trader may buy one stock and sell the other short in the expectation that the price differential will eventually revert to the mean.
Pairs trading can be a complex and risky strategy, as it requires traders to have a thorough understanding of the underlying market dynamics and the factors that influence the prices of the instruments they are trading. It can also be challenging to accurately predict when a price discrepancy will correct itself, and there is always the risk of significant losses if the trade does not go as expected.
Overall, pairs trading can be a useful tool for traders looking to take advantage of market inefficiencies and potentially earn returns, but it is important to carefully research and understand the risks involved before getting started.
The History of Pairs Trading
The origins of pairs trading can be traced back to the 1980s, when a group of quantitative analysts at the investment bank Morgan Stanley developed a computerized version of the strategy.
The original pairs trading strategy was based on statistical arbitrage, which involves identifying price discrepancies between two related instruments and then buying one and selling the other short in the expectation that the price differential will eventually correct itself. This approach was later refined and expanded upon by other traders and academics, and it has since become a popular strategy among both institutional and retail investors.
Pairs trading has evolved over time and is now used in a wide range of markets and with a variety of financial instruments. It is often implemented using sophisticated computer algorithms and software platforms that can automatically execute trades based on pre-defined rules and parameters.
Overall, pairs trading has a long history as a successful investment strategy and continues to be widely used by traders seeking to take advantage of market inefficiencies and potentially earn returns.
Advantages of Pairs Trading
There are several potential advantages to pairs trading:
Market neutrality: Pairs trading allows traders to profit from the price differential between two related instruments, regardless of the overall direction of the market. This can be beneficial in volatile or uncertain market conditions, as it allows traders to potentially profit from price discrepancies without being exposed to broad market risks.
Diversification: Pairs trading can be a way to diversify a portfolio and spread risk across different instruments and sectors. By holding long and short positions in two related instruments, traders can potentially reduce the impact of market movements on their overall portfolio.
Enhanced returns: Pairs trading can potentially enhance returns by allowing traders to take advantage of price discrepancies between two related instruments. By buying one instrument and selling the other short, traders can potentially profit from the price differential between the two.
Leverage: Many pairs trading strategies involve the use of leverage, which can allow traders to potentially amplify their returns. However, it is important to understand that leverage also increases risk and can result in significant losses if trades do not go as expected.
Automation: Pairs trading can be automated using algorithms and software platforms, which can be convenient for traders with busy schedules or who do not have the time or inclination to actively manage their investments.
Pairs Trading with ETFs
Exchange-traded funds (ETFs) can be used as part of a pairs trading strategy, as they are a type of investment vehicle that tracks the performance of a specific index, sector, or asset class.
To use ETFs in a pairs trading strategy, a trader might identify two ETFs that track related indices or sectors and then buy one and sell the other short in the expectation that the price differential between the two will eventually correct itself.
For example, a trader might pair a technology sector ETF with a consumer staples sector ETF and buy the technology ETF while selling the consumer staples ETF short, based on the expectation that the price differential between the two will eventually narrow.
Pairs trading with ETFs can be a useful way for traders to take advantage of market inefficiencies and potentially earn returns, while also diversifying their portfolio and spreading risk across different sectors and asset classes.
Below is an example of a pairs chart DIA (Dow Jones Industrial Index) vs MDY (Midcap Index) using our Buy Sell Bands indicator in TradingView. The idea is to go long the pair (long DIA / short MDY) when the pair price goes below the green line and exit when it comes back to the blue line. The vice versa goes for shorting the pair when its price goes above the red line.
