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.

　　

An example of two stocks that are co-integrated are Visa and MasterCard. Both of these companies operate similar businesses and generally have highly correlated returns. The ratio of these companies stock prices historically trade in a range, but when the ratio moves a specific standard deviation from a mean of the ratio, you can take advantage of the divergence.

Graphing Asset Pairs

One of the best ways to evaluate asset pairs is to look at them on a chart. Currency pairs are the easiest pairs to analyze because the exchange rate used is always reflected as a ratio. For example, the EUR/USD currency pair is Euros divided by dollars.

Nearly all charting software platforms provide currency cross pairs which exclude the US Dollar. Crosses include currency pairs such as the EUR/GBP or the GBP/JPY. If you do not have a software product that charts cross pairs, you can chart them on your own, by calculating the exchange rate. For example, the GBP/JPY cross pair is derived by using the formula, GBP/USD / USD/JPY.

Assets pairs other than currencies generally require some form of software flexibility. You will either need to calculate the ratio on your own or, have a charting software that provides you with this flexibility. When you calculate your pair, you should always use a ratio as opposed to the differential. So you want to use x/y as opposed to x-y.

Assets pairs other than currencies generally require some form of software flexibility.

Summary

Pairs trading is considered a market neutral form of trading that is uncorrelated to common wealth enhancing investing such as stock and bond trading. The pairs that you use in your strategy can range from currency pairs, to assets such as commodities, indices or even stocks.

The strategies that are often employed range from mean reversion quantitative strategies to trend following momentum breakout strategies. When you graph a pair, the most efficient way to analyze the pair is by dividing one asset by another. The exchange rate of a currency pair is always reflected as one asset divided by another, but you will need specific software to help you do this if you are planning to trade commodity, index or stock pairs.

You can execute a pair trades in a variety of ways including over the counter products, futures or options.

Make informed decisions with the most up-to-date and reliable financial data, exclusively provided by vtmarkets.com.