Determine the candidatesĪfter a selection process has been defined, a trader must use that process to generate a list of candidate trades. An individual trader's resources and expected trade duration will affect each of these factors, but the structure is functionally the same in all cases. It includes selecting a trading universe, constructing and testing a model, if one is to be used, and creating general buy and sell guidelines. This is the most difficult and time-consuming step in the process. As is the case with any trading methodology, the complexity and success of the final 3 steps, the actual trading, are integrally dependent on the care and skill that go into the first 3. The successful execution of each of the steps is a critical element in the process of becoming a profitable pairs trader. ![]() Perform technical, fundamental, or other statistical overlays. ![]() Transforming pairs trading from a theoretical construct into a practical reality capable of generating profits will involve several steps: Divergence traders will like to see the spread increase while convergence traders will prefer to see the spread decrease.Īnyone can use pairs trading but it has tended to be employed by professionals and those with a good understanding of short selling. The trader bets that a $50 stock and a $55 stock, for instance, will either have a larger or smaller spread ($5 in this case) when the trade is closed. In a nutshell, pairs trading works by betting that 2 or more securities will diverge or converge in price. The pairs trader attempts to measure the spread with statistics in an effort to find a tradable relationship of inequality opportunities. 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. Generally, the service road follows the highway closely but terrain or development will sometimes cause the 2 to diverge. Think of a highway and the service road that often runs parallel to it. Pairs work is based on a correlation between 2 (or more) stocks, sectors, indexes, or other financial instruments. Pairs trading is by no means a holy grail of trading and will have its ups and downs, like any other trading style. The empirical data are then dissected to unearth information that allows the trader an efficient and methodical way of executing successful trades. One of the main keys to pairs trading is finding strong correlations between financial instruments, thus building a foundation for further analysis. To measure these relationships, the pairs trader will use statistics, fundamentals, technical analysis, and even probabilities. The pairs trader attempts to capitalize on market imbalances between 2 or more financial instruments, such as stocks or funds, in anticipation of making money when the inequality is corrected. Pairs trading is a strategy that tends to use statistics to identify relationships, assist in determining the direction of the relationship, and then ascertain how to execute a trade based on the data. It can also be referred to as market neutral or statistical arbitrage. This investment strategy will entail buying the undervalued security while short-selling the overvalued security, all while maintaining market neutrality. ![]() ![]() Pairs trading is a non-directional, relative value investment strategy that seeks to identify 2 companies or funds with similar characteristics whose equity securities are currently trading at a price relationship that is out of their historical trading range.
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