An Insight on Pair Trading and How it Works

Pair trading essentially consists of investing in two stocks simultaneously. One being a long position one and the other being a short position one. These two stocks must always be related to one another. That is it must always move in one same direction. These stocks belong to the same industry sector most of the times, for example one stock of a General Motors and the other one being Ford. These stocks tend to move in the same the direction due to their nature of the business. One must be wondering then how pairing of these stocks provide a trading opportunity? It is when the two stocks, which are moving in the same direction diverge, that gives the trader an opportunity to trade and make profits.

Pairing trading requires a considerable amount of ground work to be carried out before venturing to invest in one. The smart strategy is to buy one stock that is under performing and sell a short-position out performing stock. The pair trading remains unaffected by the over-all market trend only as long the pairs are in synchronization with one another. Even if one stock falls and the other one surges up, buy as long as they possess a tendency to come back together in sync, a profit is made. The essential point that the stock market advisory services stresses on having a good discretion while selecting a pair of stocks to trade.

There are various technical tools for stock analysis available in the market that allows taking traders a shrewd decision with the help of various deviation charts and techniques. However, it is not that simple to pair trade as there are numerous factors that are to be considered to mitigated the risks or control them in case one is not able to avert. One os the major risk that is to be considered is that the divergence period between two stocks can last longer than expected, thus hampering the expected normal course of the trade. In such cases, it is best advisable to follow the long term trend following system by the stock market advisory services to predict the divergence period between two stocks. Thus traders must always draw a line when to exit from the stocks in order to avoid dire catastrophic trading conditions.

The best way to master the technique is practicing the trade over the course of time another factor to be kept in mind while trading with the pair of stocks is the volatility of the stocks. It should not happen that one stock is highly volatile in nature while the other is not. If such is the scenario then the divergence in the prices for a longer period of time is bound to happen and traders might not be able to reap as much benefit as desired. Hence, opting for highly correlated stocks with very less volatility is the key to carry out a successful pair trading at all given times.

Author Bio:

Indices Master is one of the best stock market advisory companies in India. They have years of experience in area of quantitative trading and equity research. Indices Master is a SEBI registered company.