High-Frequency Trading: Pair Trading Strategy
With the world going digital, High-Frequency trading is becoming an increasingly popular investment strategy. For those who don’t know what that is, it is simply a form of trading that is fully electronic. It utilizes computer algorithms to study several exchanges or trading platforms simultaneously; the algorithms then go ahead and place multiple buys and sell orders within a fraction of a second.
High-Frequency traders maximize on the slightest price changes. They also look out for any discrepancies between asset prices in different platforms. It is popular among institutional investors, but lately, individual traders are getting onboard. Several High-Frequency tools and platforms have been availed to optimize the traders’ experience.
Enough about High-Frequency trading. Now let’s zero in on pairs trading. When it comes to asset trading, there are so many strategies that one can apply to maximize their returns. One such advanced trading strategy is pairs trading, and in the following guide, you are about to gather all the right information to get you going with confidence.
Pair Trading Strategy
First, you need to understand that pairs trading applies across all market assets from ETFs, stocks, fiat currencies, commodities, and options to crypto. It is a market-neutral strategy best suited for people who don’t have enough time to sit in front of their screen and constantly assess the market. It is also a great strategy for pairs trader who is not so good with picking a market direction.
The second thing you need to understand is that in pairs trading, you are essentially trading the relationship between two stocks or, more often, belonging to different asset classes. You are buying one and selling the other, and you are looking for their relationship to vary. That means you are holding two positions, i.e. you are betting that two or more assets will diverge or converge in price.
Let’s say you have two securities; one is an outperforming stock while the other one is underperforming. In pairs trading, you long the underperforming asset and short the outperforming one.
Characteristics of Pairs Trading Strategy
- Pairs Trading is non-directional — this is the reason why pairs traders call it the long-short story. You essentially match a long position with a short position in two assets with a long-standing high correlation. The trader seeks to benefit from either a positive or negative deviation in price.
- Pairs Trading is market-neutral — the direction of the overall market does not affect its win or loss; it can achieve profits through simple and relatively low market risk positions.
Steps of Pair Trading Strategy
Although anyone is welcome to use the pairs trading strategy, it tends to be more common among professionals with a good understanding of short-selling. It is always good to plan your trade and approach it strategically.
It is critical to successfully implement each of the steps to make maximum profit via pairs trading. The last three steps are the most crucial for pairs trade in a practical sense. However, they heavily rely on the first three.
The recommended steps for any pair trader is as outlined below:
- Come up with an effective selection criterion based on investment research and historical trends
- Identify and list your potential trades as per past performance
- Analyze your selection through technical analysis as well as via fundamental and statistical overlays
- Initiate/perform the trade after carefully analyzing the market risk
- Manage the trade
- Complete the trade
Possible Outcomes of Pairs Trade and Their Impact on the Trader
- When the asset you are in short positions on tanks — in this case, both assets could go down in price, but as long as the one you are short on goes down more, you will make money.
- When the asset you are long on goes up further, they could both go up, but as long as the one you have taken a long position on goes up further, you will make money.
- Market Neutral — when both assets go up or down the same level, you don’t make any money.
- The best-case scenario — you probably already guessed it, happens when the one you are long on goes up while the one you are short selling goes down. In this case, you are going to make a massive profit.
Pros and Cons of Pair Trading Strategy
Pros of Pair Trading Strategy
- Pairs Trades can be highly profitable if the pair performs as expected
- Pairs Trade can help mitigate potential losses
- Pairs Trade is not affected by the general direction of the market.
Cons of Pair Trading Strategy
- Pairs trading is reliant on a high level of correlation between the assets. It can be challenging to identify such levels of correlation.
- Past prices are not always indicative of future prices; therefore, it can be tough to predict the market conditions.
Pairs Trading Strategies in Cryptocurrency
Popularly known as ‘Cryptocurrency pairs’, they are cryptocurrency assets that can be traded for each other.
A pairs trader can compare the costs between different cryptocurrencies and come up with the appropriate trading strategies.
A few examples of Cryptocurrency pairs are ETH/BCH (Ethereum and Bitcoin Cash), BTC/LTC (Bitcoin and Litecoin), and BTC/ETH (Bitcoin and Ethereum).
The most popular Cryptocurrency pairs involve a cryptocurrency and a stable coin such as USDT. A stable coin is usually pegged to the value of a fiat currency which helps simplify conversions.
A crypto investor must understand pair trading because some cryptocurrencies can only be bought with other cryptocurrencies. Equipping yourself with knowledge on pair trade, therefore, increases your chance to profit from different assets.
Most cryptocurrency exchanges offer several pairing options, giving you the chance to choose a pairing based on your portfolio. Pairings for cryptocurrencies and fiat currencies like the U.S dollar are also quite common.
To fully take advantage of crypto pair trading, you need to understand something called a base currency. Simply put, it is like a coin whose price is used as a standard to gauge the value of different assets.
In most cases, popular cryptocurrencies like Bitcoin and Ethereum usually serve as the base currency. Therefore, it is critical to explore the accepted base currencies and pair trading before starting an exchange.
In any exchange, some cryptocurrencies are more correlated with one another than others. Bitcoin is the most widely traded digital asset; it is also the most integrated coin in the crypto market.
Pairs trading in Crypto can get complicated at times; for instance, correlation tends to decrease if you are using trading pairs with limited trading volume or trading on an exchange that is not widely used. This tends to create illiquidity in the market. For this reason, one needs to exercise extreme caution and conduct enough research before making any financial choices.
NFA Disclaimer
Please note that we do not provide financial, investment, or trading advice. Investing in cryptocurrencies or tokens is highly speculative, and the market is extremely volatile and largely unregulated. Anyone considering crypto investment activities should be prepared to lose their entire investment. Invest at your own risk!
Thank You for Reading
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