- Details
- Category: Pair trading

Do you know what strategies hedge funds use? How to make money regardless of the direction of the market with a minimum risk for the deposit? The answer lies in the use of so-called **market-neutral strategies**. Private such a strategy is **arbitrage**. But unlike classical arbitrage, the use of which is available only to a limited number of persons, statistical arbitrage, of which **paired trading** is a variety, is available to all traders.

In the article we will talk about how to find statistical dependencies, what tools to use for this purpose, and what potential this technique has against the background of a more traditional single-currency trade.

**MARKET-NEUTRAL STRATEGIES**

Neutral strategy with respect to the market means that the profitability of the strategy does not directly depend on the direction of movement of the price of a particular instrument. This is achieved by creating a hedging position between two or more instruments, the profits and losses of which compensate each other.

One of the main characteristics of such a strategy is a minimal risk, since we exploit low-level market dependencies. Such strategies, for example, include market-making and arbitrage. However, unlike classical arbitrage, statistical arbitrage does not imply a risk-free profit.

In the context of statistical arbitrage, the main task is to create a market-neutral portfolio. To achieve the effect of neutrality, the portfolio must consist of highly dependent instruments, roughly speaking, so that the growth of one compensates for the fall of the other. That is, we need to create a semblance of a closed system where the funds are redistributed between portfolio instruments. Paired trading is a special case of statistical arbitrage and the most popular strategy of such a plan.

**PAIR TRADING**

By **pair trading** means simultaneous opening of positions on two interconnected instruments. Dependence is usually determined by their **correlation coefficient**. The most popular way to evaluate the relationship between two time series is to calculate the Pearson correlation. The stronger the correlation of instruments, the greater the probability of their movement in a single direction.

In this case, there is both a positive and a negative correlation. In the first case, the tools move in a co-direction. Example - GBPUSD and EURUSD.

With negative correlation, the instruments move in opposite directions. Example - EURUSD and USDCHF. Both cases are examples of strong dependence.

In pair trading, the pair's **spread** is traded, that is, the difference of the two instruments. Since we know that the instruments are moving in a single direction, it means that with the next discrepancy they will likely come back together with a high probability.

The easiest way to illustrate trading on the strategy of pair trading is based on the pair EURUSD and GBPUSD. So, if the spread (difference) between the two instruments is widened to a certain threshold, we buy a lagging instrument and sell it ahead of schedule. When the instruments come together again, we fix the profit.

The magnitude of the threshold discrepancy is determined by the statistical method, by analyzing the history of past discrepancies. For example, this may be an average discrepancy over the past year.

As a result, for us it is absolutely unimportant in which direction a separate tool will go. It is important for us that they come together, that is, their spread is returned to zero. At this point, we fix the profit equal to the size of the discrepancy.

To make this strategy profitable, there must be a constant relationship between the instruments. EURUSD and GBPUSD have a fairly strong positive correlation. However, this dependence is not constant, because of what the pair can disperse for a very long distance and do not converge back.

In fact, trading the spread of EURUSD and GBPUSD is similar to trading their cross - EURGBP.

If the pair had a permanent strong correlation, the EURGBP would always be in a flat state. However, the dependence periodically collapses, in connection with which trends are formed.

**DRAWING A SPREAD CHART**

Now we turn to the practical part - the construction of a spread of two instruments. There are different ways of calculating the spread, slightly differing in the final result. Which one should be chosen is a matter of individual preferences. The simplest way is to calculate the spread by the difference. That is, the spread formula for EURUSD and GBPUSD will look like EURUSD - GBPUSD.

You can also build a spread with respect to, for example, EURUSD / GBPUSD. It is worth considering that the resulting signals may vary depending on the chosen method, but they do not fundamentally differ.

Next, you need to decide when to enter the position. The task is to enter the market with a strong expansion of the spread, that is, when the connection between the instruments is temporarily lost. A strong expansion of the spread is an expansion more than average. Therefore, a good indicator for the entry can serve as the difference between the spread graph and the moving average.

Thus, we get the spread oscillator. To trade such a spread is extremely simple. When the line enters the overbought zone, that is, the spread has deviated significantly from the average - we sell the spread, when it enters the oversold zone, we turn the position.

In this case, to buy the spread, you need to buy EURUSD and sell GBPUSD. To sell the spread, the opposite is true: we sell euro and buy pounds.

Another method is to trade a spread from the borders of the Bollinger Channel. To do this, just add the Bollinger Bands indicator to the chart of the spread. In this case, the crossing of the canal boundaries will also indicate a significant deviation of the spread from the mean.

**CALCULATION OF THE SIZE OF ORDERS**

Another important point - the correct calculation of the size of orders for the pair position. It is logical to assume that two orders should be of equal volume, so it is enough to open two positions with the same number of lots. But not everything is so simple. If we consider the discrepancy between the instruments in points, then we assume that the points are equal for both instruments.

In fact, to equalize positions, we need to take into account the different cost of a point of two instruments relative to the dollar. Let's say you want to open a pair position for EURUSD and USDJPY. The cost of the item for EURUSD is $ 1. The value of the item on USDJPY at the moment is equal to 0.87788 $. Thus, to equalize the position sizes, the position volume for USDJPY should be 1.14 times larger than the volume for EURUSD (1 / 0.87788).

**CONCLUSION**

The most important part of the pair trading strategy is the proper selection of instruments for trading. It should be understood that the strategy itself is not a grail, but with the right selection of correlating assets it is able to produce a stable profit with minimal risk. If you want to start studying the statistical arbitrage, it's definitely worth starting with pair trading.

- Details
- Category: Pair trading

Among the variety of trading strategies that traders use in their work in financial markets, a particular place is occupied by market-neutral strategies - the strategies of **pair trading**.

**WHAT IS PAIR TRADING?**

This is a kind of trading method, consisting in the simultaneous, in most cases, multidirectional, opening of transactions by trading assets. In this case, trading assets should be interdependent. Properly selected assets have a similar reaction to market movements. For example, shares of energy / commodity companies react equally to changes in oil prices. Therefore, the multidirectional opening of positions with such instruments allows you to hedge / insure against predictable energy flows to some extent. By the way, for this reason, this type of strategy is called market neutral, because they are not much dependent on market movements.

To better understand the principles of interaction of trading assets in pair trading, you can consider an example. There are many similar products on the market that have similar characteristics, have similar parameters, but differ in price. The buyer will naturally choose the product that will be cheaper, since he does not consider it necessary to overpay for analogs with the same quality characteristics.

Gradually, cheap goods will gain popularity, and its price will begin to grow along with the increase in demand for it. That is, market mechanisms begin to influence its price, and after a while we will see that both goods, both expensive and cheap, equalize in price and will have approximately the same value. In this case, the goods do not necessarily have very similar characteristics. The difference in the characteristics of goods, and as a consequence, the difference in their price, is taken into account in paired trade in the form of weight coefficients in the spread. We, as it were, use the weighting factors of the spread to bring goods to the form, in which we can compare them.

**FACTORS, WHICH AFFECT THE CHANGE IN MARKET RATES**

The rates of various trading assets are constantly changing. These changes occur in a fairly large range, and to see this, it is enough to look at the statistics of historical values over the past few years. Many factors influence the change in the rates of trading assets. Here are the most significant of them:

- news background of the world market (macroeconomic indicators);
- economic events;
- social and political news;
- force majeure circumstances and extreme events, floods, terrorist acts, earthquakes, fires and similar events that affect the exchange rate fluctuations, various trading assets and instruments.

Note that it is practically impossible to predict the above events, and given that they cause significant movements of world markets, these events are one of the factors of "market uncertainty" / chance.

Most financial market assets / instruments have internal relationships. The reason lies in the increasing globalization of the economies of the world, the interpenetration of world capital in the economies of all countries. If in any country there was an event that affected the change in the exchange rate of the national currency (whether in a positive or negative aspect), then due to these interrelations, this event will necessarily affect the general news world background and the exchange rate of other countries.

All events taking place in the world change the general equilibrium of global assets for a while, but in the future it is restored at about the same level. It is this feature that is used in paired trade. Those. The portfolio of assets is traded at the moments of "unbalancing" towards its historical significance.

**WHAT IS THE SPREAD ON THE FINANCIAL MARKET AND HOW IS IT CALCULATED?**

**Spread** - this is the price difference, between the quotes of trading assets. In this type of trading, a spread means the difference between the quotes of two instruments in a pair, with each instrument participating along with its weighting factor.

The general formula for calculating the spread is: *Spread = a * PriceA - b * PriceB*.

Where, *a* and *b* are weights that are used to balance asset positions.

*PriceA* and *PriceB* are the prices of trading assets.

In general, the amount of deviation of the spread from its average value shows the magnitude of the "imbalance" of trading assets.

**SPREAD AS A TRADING ASSET**

It should be noted that the spread, like any trading asset, can be traded. The way of trading a spread is similar to trading, any other instruments, with the difference that in this case the position (spread) means the aggregate of two differently directed positions. Spreads (a set of positions) are also called synthetic trading assets.

The purchase of a spread is understood as the simultaneous purchase of one, and the sale of another instrument. Under the sale - on the contrary, the simultaneous sale of one and the purchase of another instrument. Volumes / values of the lots of assets that must be taken for transactions should be proportional to the weight of the spread.

To build a trading system for spread trading (pair trading), you need to have historical spreads. The deeper the history is available, the more reliable a trading system can be built. One of the trading ideas is that schedules of well-constructed spreads often return to some medium value. To implement the trading algorithm, the average lines, imposed on the spread schedule, are often used. If the spread from the middle line deviates by a predetermined amount, the transaction opens to the middle line. It closes when the spread and the middle line converge. It remains for the trader to choose the values of the deviations and the period of the middle line. Of course, to build a trading algorithm, you need to have specialized software that can work with spreads. Unfortunately, such software is not cheap, but costs, as a rule, pay off handsomely with the correct approach to trading.

**MATCHING PAIRS FOR SPREAD TRADING**

One of the main tasks in the pair trading is the proper selection of trading assets to build a spread. It is necessary to find those assets whose spread will constantly return to the average value and all traffic of the graphs will be concentrated within the limits of some channel. Trading such a pair is quite simple and enjoyable, and the attendant risks are minimal.

There are several ways to find trading assets for a spread.

- Independently, using the correlation tables of trading instruments.
- Use paid / free services that publish finished spreads.
- Specialized programs for constructing / analyzing spreads.

It is not easy to choose pairs manually, especially for beginners, because of the large number of different assets, which number is not one thousand. The trader needs to analyze the market, determine the reaction of assets to the news background, and then manually select the weights of the assets and evaluate the resulting schedules and the quality of the spread.

Easier, more efficient and faster can be matched with specialized and automated programs. They can be found on various web services that allow you to make the right selection of pairs using filters in online mode. For example, there are services in which it is enough to conduct a trading asset of interest to a trader and the program independently, taking into account the historical data, he will select a pair. As a result, the trader receives a ready spread along with the charts and weights of the incoming instruments.

There are also more complex programs that allow you to select not only pairs of assets, but also spreads from several tools. Usually such services are used by more experienced traders who have trading skills and experience.

**CONCLUSION**

The use of multidirectional trading positions (spread trading) allows to significantly reduce the influence of little predictable market factors and use short-term imbalances in trade assets in trade. In this, in its reliability, regardless of the current market conjecture and scientific validity, paired trading / spread trading has a significant advantage over other trading methods.

The spread of computers, as well as the availability of historical data in trade quotes, make this type of trade accessible to a large number of traders.