What Is Pair Trading: Meaning, Benefits & Strategy

What Is Pair Trading: Meaning, Benefits & Strategy

In the stock market, buying or selling two strongly connected equities at the same time is known as "pair trading." The goal of this technique is to make money off the price discrepancy between two equities that are predicted to move together. Doing online share trading you can customize multiple trading strategies to move with the market conditions and manage your investment portfolio.

Pair trading is a type of statistical trading that aims to profit on the fact that two stocks with a high degree of correlation would eventually move in the direction of their mean values. As you can find, these strategies are used for various opportunities in the stock market, and you can explore and implement them using a stock market app

The Key Components of Pair Trading in the Stock Market

Here are a few key components of pair trading in the Indian stock market.

Stocks with High Correlations

Stocks from the same industry or sector are frequently picked for pair trading because they frequently move in unison as a result of comparable market forces. To find companies with a high connection, traders employ statistical tools like correlation coefficients.

A Market-Neutral Approach

Pair trading acts as a market-neutral technique, meaning it is made to be lucrative no matter the direction the market is moving in. Because of this, it is a method that traders who wish to lessen their vulnerability to market risk find appealing. In order to profit from the difference in their prices, pair trading entails placing an extended position in one stock & a short position in another.

Reduced Risk

Due to the simultaneous trading of two equities, pair trading is a relatively safe method. The trader lowers the risk of holding a single stock by establishing a long position in a particular stock and taking a short position in another. In addition, the strategy is built to be successful regardless of the market's overall trend.

Statistical Analysis

Pair trading necessitates a solid grasp of statistical analysis in addition to the variables influencing the values of the two equities being traded. To establish the points of entry and exit for a trade, traders compute the mean ratio among the two equities using statistical methods. The method entails a number of steps, including picking the two stocks to trade, figuring out their correlation, and figuring out when to enter and quit the trade.

Points of Entry and Exit

Statistical tools like correlation coefficients are used by traders to determine the entry and exit locations for a trade. The trader takes an extended position in the stock that is discounted & a short position in the stock that is overvalued when the ratio deviates from its mean. After which, the trader keeps the positions open until the ratio reaches its mean value, at that point the trades are ended.

Liquidity

The liquidity of the chosen equities has an impact on the performance of pair trading on the stock market. To ensure that they can join and exit positions swiftly, traders must make sure the equities they select for pair trading have an adequate amount of liquidity.

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Table of Content

  1. The Key Components of Pair Trading in the Stock Market
  2. Some of the Popular Strategies for Pair Trading in the Stock Market
  3. Benefits and Risks of Pair Trading
  4. Conclusion

Some of the Popular Strategies for Pair Trading in the Stock Market

Statistical Arbitrage Strategy

A common method is statistical arbitrage, which includes finding mispricings between two strongly connected equities using statistical measurements. Using this strategy, trades are placed when the ratio between the two stocks deviates from its mean and the mean ratio is identified. The trader opens long positions in the inexpensive stock and short positions in the overpriced stock. This approach has the ability to make money throughout both bull and bear markets by taking advantage of market inefficiencies.

Mean-Reversion Strategy

Another well-liked approach is known as "mean-reversion," which entails finding the average ratio between two equities and placing trades whenever the ratio deviates from its average. The trader opens long positions in the inexpensive stock and short positions in the overpriced stock. The foundation of this technique is the idea that the ratio will eventually return to its mean and that the trader will earn when this occurs. 

Fundamental Analysis Strategy

In order to spot potential disparities in their valuations, fundamental analysis is an approach that entails examining the financial records of two strongly connected stocks. The trader opens long positions in the inexpensive stock and short positions in the overpriced stock. This technique aims to profit from market inefficiencies brought on by variations in the fundamental underpinnings of the two stocks.

Technical Analysis Strategy

The goal of technical analysis is to find trade opportunities by evaluating charts along with additional technical indicators. To determine the entry and exit locations for the trade, the trader makes use of technical indicators like moving averages, oscillators, along trend lines. This approach can be profitable in both bull and down markets because it is intended to take advantage of short-term price changes.

Benefits and Risks of Pair Trading

Stock market traders can gain from pair trading in a variety of ways. The fact that pair trading is a marketplace-neutral strategy, which implies it is intended to be lucrative regardless of the course of the general market, is one of its key advantages. Because of this, it is a method that traders who wish to lessen their vulnerability to market risk find appealing.

The ability to profit from the link between two highly related equities is another advantage of pair trading. Traders can profit from the price differential between these two stocks as they converge toward their mean values by establishing a long position in a stock that is undervalued and a short position in an overpriced stock. 

Conclusion

In the stock market, buying or selling two strongly connected equities at the same time is known as "pair trading." It is a price-neutral technique made for profit from the gap between the prices of two equities that are predicted to move in lockstep.

As you know what is pair trading and its characteristic such as it is a low-risk approach that entails having positions in two stocks at once to lower the risk of holding only one. Statistical measurements are used by traders to establish the entry and exit points for a trade as well as the mean ratio between the two equities. The availability of the chosen equities is another factor that influences pair trading success. As with the above knowledge about online share trading strategies you can use the pair trading as per your trade in ease.
 

Pair Trading FAQS

Traders sometimes seek out companies with a high historical correlation, or a tendency for their prices to move in tandem. Additionally, they might take into account variables like market value, industry or business, and its liquidity.

The correlation factor, beta, and mean reversion are some frequent statistical indicators used in pair trading. Additionally, traders may employ technical tools like Bollinger Bands or moving averages.

Traders can choose from a number of techniques, such as mean reversion, moving averages, & technical indicators, in order to figure out when to enter and quit a trade. On the basis of their predicted return and risk tolerance, they can additionally establish stop loss and take profit levels.

It is possible to pair trade stocks from various sectors or industries, but traders may want to take into account the potential effects that macroeconomic events or news particular to their business may have on their pair trade.

Market risk, correlation risk, & liquidity risk are a few hazards connected to pair trading. By diversifying their holdings, choosing their pairs wisely, establishing stop loss levels, and continuously monitoring their positions, traders can reduce these risks.