The secrets of forex trading - pair trading
The paired trading strategy was discovered in the 1980s by a group of quants working for Morgan Stanley. Since then, this strategy has been a staple in many large investment banks and hedge funds. However, as large investors prefer not to share the secrets of forex trading, pair trading remained unknown to the general public for a long time, until the advent of the Internet. Now, with the spread of online trading, many trading strategies, including pair trading, have become available to ordinary traders.
What is the secret of the pair trading?
The strategy is to find two highly correlated trading instruments and open a sideways position every time the difference between their prices (with consideration of the scaling factors) exceeds its historical average by a specified amount. Such trading relies on the fact that the price difference will always tend to return to its average value, which means a profit will be made on one or both positions. It is important to note that paired trades always remain neutral to the market, i.e. the general direction of the market does not affect their gain or loss.
Pair trading strategy works well not only with equities, but also with currencies, commodities and even options. In forex, Contracts for Difference (CFDs), which require considerably less diversion of funds than the underlying asset, allow small investors to use pair trading with success.
How to select pairs?
The first step in pair trading strategy is to find two instruments which are highly correlated. Typically, this means they must be from the same industry or sector, but it does not have to be. As an example, consider the stocks of two highly correlated companies: GM and Ford. Since both companies are American automakers, their stocks tend to move together. To see this, just overlay their price charts on top of each other.
However, it is difficult and not always efficient to make a pair based solely on economic analysis and fundamentals. First of all, you need to be an expert in the field and have a sufficiently good understanding of the situation in the companies in question, and secondly, even with the necessary knowledge and information, it is very laborious to manually look through many combinations of currency pairs in order to evaluate their suitability for pair trading. Besides, relying only on fundamental considerations it is possible to miss a lot of promising pairs connected with dependencies about which even an experienced analyst may not guess.
That is why institutional investors have long started using in their practice various statistical methods to select promising pairs. The simplest and best known method is calculation of pair correlations of instruments with further selection of pairs that have high correlation coefficient (more than 80%). Now you can find a lot of services with already calculated correlation coefficients on the Internet.
How to trade?
Potential points of entry into the position can be identified by plotting the spread between the instruments. In this case, the spread means the difference in prices of these instruments, taken with the scaling coefficients. Coefficients are needed in order to bring instrument prices to comparable values.
Using the spread chart, it is easy to determine the moments of price divergence. To do this, just draw a moving average of a sufficiently long period on the chart - it will show the stable historical correlation of prices of instruments. And then - track the spread deviations from this average. When the deviation exceeds the specified level, a paired deal can be opened: a long position on the undervalued symbol and a short position on the overvalued one. The optimal level is easily determined by historical testing.
Pair trading is one of the few trading strategies that have proved itself over time. Unlike various "shamanistic" methods of tehanalysis, such as chart analysis, Elliott waves or Fibonacci numbers, this strategy has a rigorous scientific foundation.