Guide to Pairs Trading

When two assets are positively correlated, it means that their values move in the same direction. You can calculate this yourself by using a spread sheet like excel.

　　

During the dog days of summer, when the markets are typically choppy, it can be difficult to find appealing directional trade candidates. When markets are choppy you can look for market neutral strategies to make income and stay active in your trading.

Pairs trading is a market neutral strategy where you look to generate income based on the value of one asset relative to another. Pair trading is a relative value strategy, as it does not depend on the outright direction of the broader markets but instead produces returns based on the ratio between two different assets.

Asset pair trades, other than currency pairs, are transacted by simultaneously initiating long and short positions in an effort to benefit from the change in the ratio of one asset by another. Assets that you can include in your pair trading strategy include commodities, indices, stocks, and of course currencies.

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Finding Asset Pairs to Trade

There are dozens of assets pairs to trade, but to enjoy success, you want to base your strategy around pairs that move in tandem. Currencies, commodities, indices and stocks that have returns that are correlated move in tandem for a reason. For example, stocks that are in the same sector, such as Coke and Pepsi are likely highly correlated. Gold and silver, oil and gasoline, as well as many currency pairs are correlated. For example, the GBP and EUR are strong trading partners, so it makes sense to believe that their currencies would be highly correlated.

When two assets are positively correlated, it means that their values move in the same direction. You can calculate this yourself by using a spread sheet like excel. The goal is to compare the changes in the price of each asset over a specific period of time

Many traders make the mistake of evaluating the price of each assets as opposed to the changes in the price. Make sure, if you are planning to determine if two different assets are correlated, that you compare the returns, as opposed to the price.

Gasoline and oil, on the other hand, are co-integrated, as gasoline is derived from oil.

A correlation of one, means that two assets move perfectly in tandem. A correlation of negative one means that the returns of the two assets move in the opposite direction and are inversely correlated.

While correlation describes the returns of two different assets, the statistical measure co-integration describes how well each assets returns are linked, and the strength of their correlation. An example that is often used to describe co-integration is an old man that is walking his dog that is on a lease.

The two can move independently, but because they are linked by a leash, there random paths will eventually converge.

An example using securities is as follows. Gold and oil prices might move in tandem for a period of time, but there is no link between the two commodities, so over time, the correlations will break down. Gasoline and oil, on the other hand, are co-integrated, as gasoline is derived from oil. Over time, the two assets will move in tandem and even if the link occasionally breaks down, it will eventual bounce back.

Co-integration is represented in a manner that is similar to correlation. A co-integration of 1, means that the pair is perfectly co-integrated, while a co-integration of -1 means that there is absolutely no co-integration. You can measure the co-integration of a cross currency pair by breaking it down into currency pair versus the US dollar. For example, you could take the GBP/USD and run a co-integration study versus the USD/JPY, to determine if the GBP/JPY is co-integrated.