A pair trade involves trading two stocks that are usually moving together in a similar manner. The idea behind pair trading is to profit from the difference between stock prices. The concept of pair trading was introduced by the Morgan Stanley group of technical analysts in the mid-1980s. In this article, let’s understand what is pair trading, how it works, and the pros and cons.

What Is Pair Trading?

Pair trading is a strategy where you invest in two different stocks that usually move together in a similar way. You buy one stock and sell the other. Instead of hoping that both stocks go up in value, you’re trying to make money from the difference between their prices.

People who do pair trading usually pick two stocks that are in the same kind of business and are about the same size in terms of their total value. By buying one and selling the other, they’re trying to make a profit when the prices of these two stocks change in different ways.

Pair trading is popular because it can be a safer way to invest, especially when the stock market is unpredictable. Understand futures trading charges, before doing pair trading.

Let’s understand a real-world example. Take two popular Indian bank stocks, ICICI Bank and HDFC Bank. Normally, they tend to move in sync, with a high correlation of 0.95. But let’s say the Reserve Bank of India (RBI) introduces some rules that affect HDFC Bank’s credit card business, causing its stock price to drop significantly. As a result, the correlation between these two banks may temporarily decrease to 0.50.

In this situation, you might decide to buy HDFC Bank and sell ICICI Bank. By doing this, you can make money when HDFC Bank’s stock price goes up again, and the correlation between these two banks returns to its usual high level of 0.95.

How Pair Trading Works?

Pair trading is a strategy where you look for two stocks that usually move together. These two stocks can be from the same industry or compete with each other. The idea is to make money from the difference in their prices.

So, you find two stocks that tend to go up and down at the same time. You buy one of them and sell the other. You hope that if one of them is not doing well, it will eventually go up, and the other will go down. With this method, you can earn money from the difference in prices.

But be careful, pair trading can be risky. You need to choose the right pairs of stocks and keep an eye on the market and the economy to ensure things are going as planned.

Pros of Pair Trading

Following are the pair trading advantages:

Saves Time 

Pair trading doesn’t require you to study the entire stock market. You just focus on two specific stocks, which can save you time and effort.

Market-Neutral

This strategy works in different market situations, making it easy to use in most conditions.

Adaptable

Pair trading can be customized for different types of traders. If you like quick trades, you can use a short time frame. It’s also flexible in terms of risk management.

Risk Management

You can set a stop loss, which means if the stocks you’re trading separate too much, the trade will automatically end. This helps control potential losses.

Cons Of Pair Trading

However, there are a few downsides to pair trading strategies. Here are they:

Uncertainty 

There’s no guarantee that the difference in performance between the two stocks will be temporary. It could last longer if something big changes with one of the companies.

Difficulty Finding Pairs

It can be hard to find two stocks with a history of moving together. This might make the strategy better suited for experienced traders only.

Nowadays, you can use a share market app to help you with pair trading. These apps provide tools to make trading easier and more accessible.

Conclusion

In pair trading, you’re trading two different stocks at the same time. Here the goal is to profit from the differences in these stocks’ prices. When the stock market is volatile, this strategy is effective. But remember, pair trading isn’t completely safe; you need to pick stocks that usually move together. If you’re interested in trying pair trading in India, Share India is a trustworthy financial service provider that can guide you through the process and provide the tools you need.