Pairs trading is a market-neutral strategy that boasts several advantages:
Central to pairs trading is the matching of a long position with a short position in a related, or correlated, instrument. This essentially creates an automatic hedge, where one leg of the trade acts as a hedge against the other. In this manner, risk is somewhat controlled. Consider an example where a trader is long on stock ABC and short on stock XYZ in a pairs trade. Since the two stocks are correlated, if the entire sector takes a hit, the price may fall for both stocks. In this example, any losses sustained through the long position will be mitigated by the gain in the short position. Therefore, even though the entire sector is down on the day, the trader’s net position may remain neutral because of the low correlation to the market averages.
Profit regardless of market direction
Another attractive feature of pairs trading is the ability to profit whether the market is going up, down or sideways. This is because the strategy does not depend on market direction, but on the relationship between the two instruments. To clarify, long-only traders (who are bullish) can only profit from rising markets. Short-only traders (who are bearish) profit when the markets are falling. To a pairs trader, the market direction does not matter; it’s the relative performance of the two instruments that determines each trade’s outcome.
No directional risk
Directional risk involves exposure to the direction of price movements. For example, a long position is exposed to the risk that stock prices will move down. In pairs trading, a second instrument acts as a hedge against the first, thereby removing the directional risk. Because profits depend on the difference in price change between the two instruments, rather than from the direction in which each moves, directional risk is removed.
A drawdown is a peak-to-trough decline in an open investment’s value. For example, if a trade reached unrealized profits of $10,000 one day, and the next day fell to $6,000, that would indicate a $4,000 drawdown. While drawdowns do not necessarily dictate whether a trade will ultimately be a winner, managing drawdowns is important because it’s money that is at risk of being lost. In addition, a strategy’s maximum expected drawdown (based on historical modeling) will determine how much money a trader needs to allocate to that particular strategy. For example, if a strategy has a maximum drawdown of $5,000, we would need access to at least $5,000 to cover any potential losses. Because losses from a losing position are tempered by gains in a winning position, pairs trading generally involves smaller net drawdowns.
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