Pairs Trading for Beginners: Correlation, Cointegration, Examples, and Strategy Steps

The correlation coefficient indicates the degree of correlation between the two variables. Discover how to trade – or develop your knowledge – with free online courses, webinars and seminars. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.

  1. If the securities return to their historical correlation, a profit is made from the convergence of the prices.
  2. The center white line represents the mean price ratio over the past two years.
  3. Geert Rouwenhorst, the authors attempted to prove that pairs trading is profitable.
  4. To distinguish profitable results from plain luck, their test included conservative estimates of transaction costs and randomly selected pairs.

It indicates which security the trader should sell short and which security the trader should buy, and when. In an important research paper written by Yale Business School economists Even G. Gatev, William Goetzmann, and K. Geert Rouwenhorst, the authors attempted to prove that pairs trading is profitable. Using a large set of data from 1967 to 1997, the trio found that over any six-month trading period, the pairs trade averaged a +12% return. To distinguish profitable results from plain luck, their test included conservative estimates of transaction costs and randomly selected pairs. Below is a weekly chart of the price ratio between Ford and GM (calculated by dividing Ford’s stock price by GM’s stock price).

Pairs trading summed up

Pairs trading is a strategy that involves using two positions, one short and one long, on two markets with high correlation. It can be used across equities, indices, FX or commodities, or any combination of markets. More recent research has also shown that pairs trading can still be a profitable venture, although the advent of algorithmic and high-frequency trading (HFT) has left this business largely to the professionals these days. Pairs trading relies on the securities having a high statistical correlation. Most of the traders require a correlation of at least 0.80 which is very challenging to recognize. In a profitable situation, the mean would be approaching zero or very close to it.

What Is Pairs Trading?

When the futures contract gets ahead of the cash position, a trader might try to profit by shorting the future and going long in the index tracking stock, expecting them to come together at some point. The pairs trading strategy works not only with stocks but also with currencies, commodities, and options. In the futures market, “mini” contracts—smaller-sized contracts that represent a fraction of the value of the full-size position—enable smaller investors to trade in futures. When the pairs trading strategy performs as per the trader’s expectations, the potential losses are mitigated.

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Now, both ‘a’ and ‘b’ increase in such a way that the value of the spread decreases. This will result in a loss since stock A is increasing at a rate lower than stock B and you are short on stock B. Moreover, you can check out this informative video below to find out how pairs trading works.

The man and his dog are correlated, and the times when the dog moves away from the man are examples of the ratio between two markets becoming stretched. Correlations can change over time, and strengthen and weaken, as well as changing their correlation from positive to negative. However, companies in the same sector, such as supermarkets, or mining, usually see their correlations remain constant.

But the loss on one position is tempered by profits on the other, and thus the expected drawdown of the strategy can be smaller. 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 net developer skills you must consider while hiring list of candidates. A trader who intends to hold a given position for several hours to several days will need to generate candidate trades with far greater frequency than a manager whose average holding period is measured in months. It includes selecting a trading universe, constructing and testing a model, if one is to be used, and creating general buy and sell guidelines.

Given a normal distribution of raw data points, the z-score is calculated so that the new distribution is a normal distribution with a mean of 0 and a standard deviation of 1. Having such a distribution ~ N(0, 1) is very useful for creating threshold levels. A stationary process has very valuable features which are required to model pairs trading strategies. FX pairs with the same ‘base’, eg EUR/USD and GBP/USD, can be highly correlated in a positive direction. Meanwhile, Brent and WTI can also be positively correlated in the commodities space, while many commodities tend to move inversely to the price of the US dollar.

Likewise, they must be mindful of the pair’s price action and constantly adjust the risk/return profile of the trade. For example, if a trade with an expected duration of 3 weeks were to achieve 50% of its profit objective in the first day after execution, the trader will want to reevaluate the potential reward for keeping the trade open. In such a situation, the trader could choose 1 of 2 options to prudently manage the trade moving forward. The trade could be immediately closed with a view that the additional return does not warrant the risk or the opportunity cost.

It didn’t take long for the pairs trade to attract individual investors and small-time traders looking to hedge their risk exposure to the movements of the broader market. Pairs work is based on a correlation between 2 (or more) stocks, sectors, indexes, or other financial instruments. Generally, the service road follows the highway closely but terrain or development will sometimes cause the 2 to diverge. The area between the highway and the service road can be thought of as the spread—the measured distance between the 2 objects traveling together.

How much does trading cost?

This material does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. You should not treat any opinion expressed in this material as a specific inducement to make any investment or follow any strategy, but only as an expression of opinion. This material does not consider your investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. No representation or warranty is given as to the accuracy or completeness of the above information.

Profits are generated when the underperforming security regains value, and the outperforming security’s price deflates. 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. Relying on the historical notion that the two securities will maintain a specified correlation, the pairs trade can be deployed when this correlation falters. A pairs trade in the futures market might involve an arbitrage between the futures contract and the cash position of a given index.

A put is a commitment by the writer to buy shares at a given price sometime in the future. 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. Online trading opened the lid on real-time financial information and gave the novice access to all types of investment strategies.

Technical investors will just use the price, but since the price is essentially a function of expected earnings in the future, the overall approach is the same. The length of time the trader plans to keep the trade open and his resources are two other important factors in the selection part of the trading process, as it may take quite some time for the trade to move in his favor. The reason for the deviated stock to come back to original value is itself an assumption.