What Is Pair Trading?

Introduction

Traders and investors use pair trading to leverage market inefficiencies. It can be a valuable tool for traders looking to diversify their portfolios and mitigate risks in the market. This blog delves deeper into the world of pair trading meaning, exploring its benefits, challenges, and strategies for success.

What is Pair Trading in the Stock Market?

Pair trading involves taking a long position in one stock and a short position in another stock, which are highly correlated. The goal of pair trading is to profit from the price difference between the two stocks rather than the price movement of each stock.

In pair trading, traders typically select two stocks from the same industry with similar fundamentals and market capitalisation. By taking a long position in one stock and a short position in the other, traders aim to profit from the difference in price movements between the two stocks.

Pair trading is a popular strategy among traders as it can help mitigate risks in the market, particularly during volatile market conditions. Additionally, it can help traders diversify their portfolios and potentially generate alpha returns.

How does Pair Trading work?

The pair trading strategy assumes market neutrality and involves searching for highly correlated securities which may belong to the same industry or be direct competitors. Traders aim to profit from the price difference between the two securities as they move similarly. 

The strategy expects underperforming securities to rebound and overperforming securities to decrease in value. However, pair trading carries risks, and traders must carefully select their pairs and monitor the market and economic conditions.
 

Various Attributes of Pair Trading

The attributes of pair trading include–

●    Securities: Stocks are securities in which you can invest. Let’s consider Stock A & B.
●    Relationship: It means the relationship between Stock A & B. As both stocks behave similarly, Stock A will have a similar market impact as Stock B.
●    Relationship deviations: Relationship deviations lead to stock correlations breaking down.
●    Impact of deviation: Usually, deviation from the correlation is short-lived, and the stocks rapidly return to their previous correlation.
 

Let’s consider two companies for pair trading example– Bajaj Auto and Hero MotoCorp:

●    They both operate in the Indian automobile industry as private companies.
●    The products, target audiences, and customers of both companies are similar.
●    There is a similar volume and presence in India for both companies.
●    Regulations, constraints, and challenges are similar for both.

Since both companies are highly correlated, any changes in market conditions will likely affect them similarly. For instance, an increase in fuel prices would negatively impact the industry and the companies. Assuming all other factors are constant if the stock price of Hero MotoCorp moves in a particular direction, it is highly likely that the stock price of Bajaj Auto will move in the same direction due to their correlation.

However, if the stock prices of both companies do not move in the same direction, this is an ideal trading opportunity. As a result, pair trading usually involves the following strategies.

●    Identifying stock relationships

It is common for investors to search for securities within the same industry group or sector. Companies in different sectors tend to have lower correlations. Hero MotoCorp, for instance, will be affected by a change in raw materials, but HDFC Bank will not be affected by it.

●    Examining the stock correlations

A correlation of 0.85 is usually deemed satisfactory for engaging in fair trade. In the past year, Hero MotoCorp and Bajaj Finance have demonstrated a correlation of 0.87, which is above the satisfactory level.

●    Keeping track of the correlation daily

Correlation measures the relationship between two variables, indicating the degree of dependency on each other. The correlation coefficient ranges from -1 to 1, where; 

●    -1 indicates the perfect negative correlation
●    0 indicates no correlation
●    1 indicates the perfect positive correlation

●    Checking for anomalies in correlation

Identifying trading opportunities involves monitoring deviations in correlation, which can present both short-term and long-term opportunities for trading.
 

What Is Pair Trading in the Stock Market?

To execute a pair trading strategy, traders need to identify opportunities to trade by tracking deviations in the correlation between the securities. These deviations could be due to factors such as market conditions, company-specific events, or changes in top management.

Traders take a long position in the underperforming security and a short position in the outperforming security. It ensures that if the securities return to their original correlated state, the trader can benefit from the price movements. Additionally, entry and exit points are clearly defined, which helps traders minimise their risk and maximise their profits.

The potential for profit in pair trading can be illustrated by looking at the correlation between two securities, such as ICICI Bank and HDFC Bank. Historically, these two securities have had a high correlation of 0.95. However, if the RBI issues guidelines to HDFC Bank concerning issuing credit cards, the price of HDFC Bank could fall sharply, and the correlation between the two securities could reduce in the short term to 0.50. 

In such a situation, a trader could take a long position on HDFC Bank and short-sell ICICI Bank. Traders may profit from their long positions and closed short positions when HDFC Bank's price recovers and their correlation returns to 0.95.
 

Advantages of Pair Trading

Pair trading offers a primary advantage of risk reduction by executing opposing trades on securities with similar correlations. This strategy yields profits when the underperforming security recovers its value, and the outperforming security declines. However, successful pair trading requires a high correlation between the securities, with a minimum of 0.80. Identifying such securities can be challenging.

Conclusion

Pair trading can help traders diversify their portfolios, mitigate risks, and potentially generate alpha returns. The strategy assumes market neutrality and involves identifying highly correlated securities, monitoring deviations in their relationship, and executing trades based on any temporary deviations. While the profit potential is high, pair trading also carries risks, and traders must carefully select their pairs and monitor the market and economic conditions.