Pair Trading is a market neutral trading strategy. It can be deployed in all kinds of markets i.e., bearish, bullish or in a range bound market.
In pair-trading, two stocks will be deployed. Opposite positions will be taken in both stocks that means in one stock, trader executes a long position and in another one, he will go with short.
Let us see how to select stocks for pair trading and the process of executing one.
- To execute a pair trade, a trader has to select two stocks which involved in the same kind of business (same sector), whether it may be auto, pharma, oil and gas or any other sector.
- Let us say you selected AUTO sector. Next step is you need to do is to pick two stocks in that sector. But before that, you need to check the correlation between both of them.
- Select the stocks with a correlation of more than 85%. If the correlation is high there is a high chance for both stocks to move in the same direction.
- Finally, you got two stock with high correlation. Now what you have to do is wait for the opportunity. It needs a lot of patience.
- Usually, due to some temporary reasons like bad news in one company, the announcement of results or it may be any other force. The stock price of one stock deviates from the path.
- This is the time where the trader gets the opportunity.
- But one more criteria trader has to check is “How much the stock got deviated from the mean price?”, “What is the Probability of the stock getting back to the mean?”
- To calculate these, traders use standard deviations and values of the density curve.
This is the first article in the pair trading series. I hope you got a basic idea of pair trading. In upcoming articles, I will dig deep into all 8 steps mentioned above and videos will be published for better understanding.