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Pairs trading is a popular way to alleviate some of the risk of trading. The idea is that you find two highly correlated symbols or two very lowly correlated symbols and enter a position in both symbols. If the pair is highly correlated , they should move in the same direction. Typically, an opportunity presents itself when the pair ratio breaks through a threshold that is a certain number of standard deviations away from their average standard deviation.
You would then, go long in the symbol that is under-performing and short in the symbol that is over-performing. When the pair moves back towards its average deviation, you would then close out both positions. Many technical analysts use the Bollinger Bands indicator to spot pairs trading opportunities. In example below, Bollinger Bands are set to be 2. A pairs trade is designed to be market neutral. This means that because of the positions that you take in two separate instruments, the direction of the market will not effect the position.
The trade is designed to profit from the relationship between the two instruments, not the direction of the market itself. Correlation moves along a scale of -1 to 1 with 1 meaning the instruments are perfectly correlated. Keep in mind that pairs trades can also work with pairs that are extremely negatively correlated close to When setting up a pairs trade with negatively correlated instruments, you would want to enter the positions when the two contracts are closer together than usual with the anticipation that they will move apart in opposite directions.
In this case, you would enter positions in the same direction for both instead of going long in one and short in the other. Another important piece of the puzzle is position size. The whole idea is to be market neutral. Therefore, you would not simply enter the same number of shares or contracts for each instrument.
You would want to create the same actual dollar value in both positions. If you strictly use an equal number of shares on both sides and the dollar value of the two instruments are wildly different, then the side with the higher dollar value will have way too much weight in the trade. You will notice in the below example, that simply using the same number of shares for both instruments will result in an extremely unbalanced trade in terms of dollar value.
The number of shares should be modified in order to get the dollar values as close of possible. It will rarely if ever be exact but getting as close as possible is important.
The key to pairs trading is the correlation between the two instruments. One thing that many traders fail to realize is that the correlation between instruments is ever changing. Brent Crude Oil nymex. Light Crude Oil Pit nymex. Brent Crude Oil ipe. Soybean Oil gbx cbot. Mini Sized Wheat gbx cbot. Alberta Barley ice futr. Nikkei Yen cme. Continuous CRB Index ice futures. Nikkei gbx cme. Fed Funds 30 Day cbot. Copper High Grade gbx comex. Copper miNY gbx comex. Silver oz comex.
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