Pairs Trading Strategy and Statistical Arbitrage – Suitable For trading on the internet

 

Pairs trading strategy is a market neutral strategy that allows traders to profit from almost all market conditions, whether the market is in uptrend, downtrend or sideways movement. Although introduced in early 1980, the strategy became popular among retailers after the introduction of online trading, through sophisticated trading systems. Opportunities for pairs trading usually last for only a short period so quick response to market movements are needed, which can only be achieved by a high degree of automation.

The first and most important step in pairs trading strategy is to find pairs. Pairs securities (stocks, options, futures, currencies, bonds, etc.) ) Which shows a high correlation, it is if the price movement of one is in the same direction of the others. For stocks, shares may be pairs of two companies in the same (or related) industry. For options, there may be options for very-related shares. For Futures can it can be mini- or full-size contracts or futures contracts related to (the same) industries. And for forex it may be currencies of countries with good trade relations. Traders should use various fundamental and technical analysis tools for these sets. Once identified pairs of the strategy is simple.

Pairs traders seek to find a divergence of correlation between shares in a pair. When a divergence is noticed, the traders take the opposite positions of the instruments in a pair. For stocks, currencies and futures, the trader takes long position in under performing instrument and short position of performing instrument; for options, “the trader uses put option for the poor performing stock and call option for the outperform stock. In most cases the costs of taking a position is offset by income from the opposite position. Trader has profited when the divergence is corrected and the instruments are brought to the original (near the original) correlation of market forces.

Pairs trading strategy demand good position sizing, market timing and decision-making skills. Although the strategy has little downside risk there is a lack of opportunities and, for profiting, the trader must be one of the first to take advantage of that opportunity.

Statistical Arbitration, popularly called StatArb, is the wide range of pairs trading strategy. Strategy is to take advantage of pricing inefficiencies in the market and to make profit by detecting deviations from the correlation. But unlike pairs trading, StatArb has downside risks.

In statistical arbitrage, traders have portfolios consisting of a number of different stocks, carefully adjusted to reduce stock market risk and beta. Stocks have been carefully screened using fundamental and technical tools, which include industry, beta, volume, growth, value and performance history. Normally stocks in the portfolio are scored with a mean-diversion principle and other mathematical models. Typically, stocks that are underperforming get high scores, and outperforming stocks get low scores. Strategy is to take a long position in the high score stocks and take short positions in low-valuation stocks.

With both pairs trading and statistical arbitrage continuous data mining, market and price analysis and price matching is important. High position sizing, low transaction costs and better trading platforms provide better gains.

 

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