1. Pairs Trading: Introduction
  2. Pairs Trading: Market Neutral Investing
  3. Pairs Trading: Correlation
  4. Arbitrage and Pairs Trading
  5. Fundamental and Technical Analysis for Pairs Trading
  6. Pairs Trade Example
  7. Pairs Trading: Risks
  8. Disadvantages of Pairs Trading
  9. Advantages of Pairs Trading
  10. Pairs Trading: Conclusion

Pairs trading is a market-neutral strategy that boasts several advantages:
Controlled risk
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.
Smaller drawdowns
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.

Pairs Trading: Conclusion

Related Articles
  1. Investing

    Four Steps To Manage A Downturn In The Market

    A few simple adjustments could end your losing streak as soon as it begins.
  2. Trading

    The Secret To Finding Profit In Pairs Trading

    Read about a market-neutral trading strategy using relatively low-risk positions.
  3. Investing

    Why Goldman Says Equity Investors Have No Safe Haven (GS)

    Explore the reasons behind Goldman Sachs' forecast for increasing drawdowns in the market, similar to the corrections of 11 and 13% in 2015.
  4. Investing

    Interpreting A Strategy Performance Report

    These key performance metrics will help you decide if your trading strategy is a winner.
  5. Trading

    No Forex Strategy Of Your Own? Try Mirror Trading

    There are many advantages to trading a mirror strategy, yet markets are dynamic, and regardless there is always a risk of losses.
  6. Investing

    For Maximum Market Returns, Get Creative With Hedges

    Proper hedges help to contain your losses while still allowing profits to grow.
  7. Trading

    Top Day Trading Instruments

    Day trading is an intense and often appealing activity. Investopedia provides the list of top financial instruments for day trading.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center