What is Pairs Trading?
The concept of pairs trading is disarmingly simple. Find two stocks whose prices have moved together historically. When the spread between them widens, short the winner and buy the loser. If history repeats itself, prices will converge and there will be profit. It is hard to believe that such a simple strategy, based solely on past price dynamics and simple contrarian principles, could possibly make money.
Traders use Pairs Trading strategies because the idea is simple and the traits to look for are minimal. It may sound fool proof to you but it is crucial to highlight that deviations may be caused by macroeconomic factors, which generally distorts chart patterns and renders the trading strategy invalid.
Pairs trading was developed by a quantitative group at Morgan Stanley during the 1980s, who reportedly made over US $50 million for the firm in 1987.
In statistics, Pairs Trading uses the concept of stationary pricing. When a price movement is stationary, the mean and variance are constant. Therefore, if there are deviations away from the mean, reversion of prices will occur towards the mean.
How to choose a good Pairs Trading Stocks
This is like the most difficult part of the process, but it’s actually quite streamlined in its most raw form. There are numerous complicated methods for choosing the pair of stocks, but it all boils down to finding two stocks that are correlated in movement. Start out by looking for stocks that make sense to be similar. Choosing a pair to trade on is, by no means, coincidental as mentioned in the name of this trading strategy.
Choosing a pair to trade on is, by no means, coincidental as mentioned in the name of this trading strategy. There are various questions you may ask yourself: “Do they need to be in the same industry?” “Should they be only liquid stocks?”. In pairs trading, there is no hard and fuss rule as to how you choose your pairs. Most importantly, traders look for asset classes whose price movements are similar
A Pairs trading approach gives us a good frame work for utilizing today’s High Frequency trading software with a relative small downside potential.