With similar functionalities to Forex & Long Term, Pairs allows traders to predict the relative ratio between 2 assets from the same equity type (which asset will outperform or surpass the other by expiry). With regular CFD / Forex, the price of a commodity is predicted. With Pairs, a trader predicts how strong or weak one asset will be compared to another. For example, investors can trade on the performance of Gold compared to Oil, Google compared to Apple, Dow Jones compared to FTSE. The idea for Pair Options came from the universe of currency crosses and currently those instruments are a unique trading method as they are based on relative strengths or weaknesses and not on absolute strengths.
One of the biggest problems, if not the most, of stock trading is the inability of traders to control the market. Sometimes, through real work and insane financial skill, people may predict the trend. Surely, however, there is no way to immunize oneself from the upward and downward movement of the market–but there’s a way to cushion the blow and that is pairs trading.
To know how pair trading works, one must first understand the basic principles in stock trading. Pairs trading is a strategy that is market neutral. It makes use of the correlation of two securities (a pair). The more highly correlated they are, the better since it means that their trends move virtually in the same direction. The idea is to take the pair: one for the long position, meaning buying a security with the expectation that its value will increase; and one for short selling, meaning selling a borrowed security to a third party and then giving the same number of stocks to the initial lender once you can purchase the security in a much lower value from the open market.
How will you make a profit with pairs trading?
How then do you make a profit by buying two correlated stocks? Say, for example, we have ABC Cola and YES Cola. (Note that two highly related stocks necessarily mean that they are both in the same industry.) For years, the trend of these two stocks moves hand in hand with each other. It is not impossible however that at some point, the price of either one of them may drop and the other continues to soar. This is called the divergence and it is the jumping point where you can make a profit. Let’s assume that sometime around September 2016, ABC Cola’s value plummeted, inversely proportional to YES Cola whose stock soared. In September 28, the ratio of standard deviation comes to 2.5. The stocks are beginning to greatly diverge. Here is where you make the trade. We enter the trade when the ratio has a standard deviation at 2.5 and exit the trade when it becomes significantly lower. Affixing values to it may help us understand better.
You bought ABC priced at $10 on September 28, while placing a stop loss order lower than the recent low, say at $8.5 to avoid substantial financial loss. At the same time, you short sold YES near the close on September 28 at $20. Given that you have $5000 to spare for each type of stock, you can buy 500 shares of ABC and sell 250 shares of YES. You exited the trade on October 15 because the ratio has decreased from the 2.5 standard deviations to a much lower one. At this moment, it is safe to say that the price relationship has started to converge once again and move at the same trend. YES closed at $22 and ABC at $12. In the end, how much did you make? YES: $22- $20 = $2 x 250 shares= $500; ABC: $12 – $10 = $2 x 500 = $150. You made a total of $2000. This is all in the assumption that the margin for profit is healthy. While engaging in pairs trade minimizes the risks of the market, it is not the be-all and end-all of the trading game; otherwise, everyone will just resort to this.
A must remember points about of Pairs trading
First of all, for beginners, even long time traders sometimes, pairs trading is difficult to understand. Since it is not a usual strategy like an ultimate mantra, “buy low, sell high.” Not everyone can get into the game. Before entering into pairs trade, one must really understand the connection between two stocks or a pair. Ample research must be done to ensure that their correlation is not just strong at some points, but is really well-established. While it also claims to be a market neutral technique, it does not absolve the trader from all risks, after all this is the Market and risks are inevitable. One particular example is when the divergence continues to grow beyond the expected the time frame. In such case, when one company experiences a drawback like a big PR problem or the surprise existence of an infamous civil suit–something so big that value of stocks gets dragged to the ground for an extended period of time. While there is a way to put an end to losses such as placing a stop loss order, not everyone does the same. In short, while this strategy works sometimes, it requires a unique skill, one that is developed only through experience and thorough study. Something beginners generally do not have.
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