Pairs Trading is an algorithmic trading strategy built on the principles of statistical arbitrage. It is designed to take advantage of the statistical relationships between two co-moving assets. And execute actions that capitalize on price deviations and market inefficiencies. This strategy relies deeply on the understanding of statistical concepts, risk management, and timing.
Today, it is widely adopted amongst many financial institutions as a method to generate positive returns for their clients. One such firm that utilizes pairs trading as a part of its overall strategy is Virtu Financial, an American financial services provider that recorded USD 2.36 billion in revenue in 2022.
The core concept that drives pairs trading is a statistical technique called cointegration.
What is Cointegration?
Two assets are considered cointegrated when their prices tend to follow the same trend patterns over an extended time frame. While market volatility and other market factors may cause occasional deviations, cointegrated assets are highly likely to revert to their historical relationship over time.
A trading algorithm built on pairs trading seeks to identify assets that are cointegrated across various markets. Once the algorithm identifies a viable cointegrated pair, it will monitor the price action of both assets. Until such time that one asset’s price deviates from the other by a predetermined amount. When this happens, the algorithm executes a trade and holds the position until a full regression to the historical mean is completed or until the risk-reward ratio becomes unfavorable.
The Conceptual Basis of Pairs Trading
At the most basic level, pairs trading follows a similar logic to mean reversion. It is based on the concept that asset prices inherently regress to their historical average over an extended period. Under this assumption, a pairs trading algorithm will work on identifying two different assets that have displayed a strong historical price correlation. When the prices of the two assets experience a divergence, a pairs trading algorithm will take this as an opportunity for a potential reversion to the mean and will enter a trading position.
The Advantages of Pairs Trading
Pairs trading is actively used today by firms to enter positions across a wide variety of assets. Including commodities, stocks, currencies, and bonds. It lends many advantages to traders, including the following:
- Profitability: The key to profitability when it comes to pairs trading is the cointegration of assets. Say the algorithm is correct in assuming that the assets are cointegrated. Then, any diversion from the mean can be safely assumed as temporary. And prices will revert to their historical relationship over time. This presents an opportunity for trading algorithms to take profit from the resulting price action, as the asset gradually moves back to the mean.
- Simple: Due to its simplistic concept, pairs trading is ideal for traders with limited technical background.
- Relatively low-risk: Pairs trading strategies are not as sensitive to market volatility as other trading strategies. Mainly, because of their detachment from short-term price actions. As such, pairs trading is considered relatively low risk as compared to other trading strategies.
Conclusion
Pairs trading gives traders and financial institutions a powerful tool to achieve growth for their clients. While industry changes can affect the price relationship between assets, traders can employ risk management strategies to minimize their risk exposure. Hedging techniques can also be integrated with pairs trading to mitigate potential market risks. Pairs trading algorithms can be programmed to act with even greater precision across a more diverse range of financial markets than ever before with the power of AI and ML.
