The Basics of the Pairs Trading Strategy

Pairs trading is a type of investment strategy that involves investing in 2 different securities that are highly correlated to one other. By doing this, you can potentially make a profit regardless of what happens in the market as a whole. The hope is that you can go long on one security, short on the other, and make a profit when they go back to their average. Here are the basics of the pairs trading strategy and how it works.

Correlated Securities

In order to understand how this trading strategy can work, you need to understand something about correlated securities. Many different securities are highly correlated to other types of securities. When one security is doing well, the other one tends to do well also. The same applies when one of them does poorly. There are a number of examples of securities that can be highly correlated. For example, you could take 2 stocks out of the same sector in the market and there is a good chance that they would be highly correlated. Precious metals such as gold and silver are also highly correlated. When gold is doing well, there is a good chance that silver is doing well also. 

Market indices such as the S&P 500 and the Dow Jones industrial average also tend to move in sync with one another. Since these indices gauge the health of the stock market overall, they will generally move in unison.

The Strategy

In order to make this strategy work, you have to choose 2 securities that you will monitor. Once you have chosen your securities, you need to pay attention to their movements in the market. When trying to implement the strategy, you need to watch both securities on a price chart and look for opportunities when they are moving in opposite directions. One of the securities will move up while the other one will move down. These circumstances can happen for many reasons even with correlated securities. If the securities are truly correlated to one other, when this happens, you can feel fairly confident that they will come back together at some point. The one that went up will go back down towards the middle and the one that went down will move back up towards the other one. 

With the security that moved up in value, you will place a short trade against it. For the security that moved down in value, you will want to place a long order. When the security that raised in value comes back down to the other one, you will be able to net a profit from the short trade that you took. At the same time, when the security that declined in value comes back up, you will be able to make a profit on the buy trade that you placed. This allows you to make two profitable trades at the same time just because you identified two securities that were highly correlated to one other.

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