What is Pairs Trading & How It Works?

Pairs trading involves buying one security while simultaneously selling short another security, with both positions established on the same side of the market for each security. An example would be buying one share of Apple while simultaneously selling a short one share of Microsoft. You can easily make buying or selling decisions after some technical analysis, for example, a nifty chart. It can help you identify trends and patterns in the market that will allow you to make better nifty future trading strategies.

The basic idea behind pair trading is simple. Let’s say you notice that Coca-Cola and Pepsi are always of equal value when quoted at any given time. A speculative trader might go long Coca-Cola while simultaneously going short Pepsi, based on a theory that their relative values will return to normal, resulting in a quick profit. 

Suppose it works out as predicted, then great. If not, then it’s back to square one. This style of pair trading strategy requires careful attention to market movements and some foresight into how traders may react under certain circumstances; for every pair tradable. For example, in shares or futures contracts, a willing buyer and seller must agree upon a reasonable price before taking control of those assets from the other party.

 

Mathematics Aspects in Pairs Trading Formula

 

Knowing how to study a nifty bank chart can help you get an idea about finding these pairs. However, there are some mathematical aspects that you should be familiar with beforehand. One of the most popular forms of pairs trading is based on the spread between two stocks, usually ones that belong to the same sector.

Over time, this spread should revert to its mean. When it moves outside a specific range, say ±2 standard deviations from its mean, there is an opportunity to profit from reversing the mean. In other words, when stock A moves up two standard deviations relative to stock B, it is probably overbought; when it moves down two standard deviations from stock B, it is perhaps oversold.

• One way to confirm that both stocks have climbed or fallen together before diverging may be to check their correlation coefficient for past periods (e.g., look for a value close to 1).  

• Another way may be to plot their prices on a chart to form, i.e., bank nifty strategy, and draw a trend line through them. If the two stocks have been trending together for some time, they may show signs of continuing this relationship in future periods.

Pro Tip: To correctly compute an entry point as part of your nifty strategy for pair trading, we need three pieces of information: the current price for each stock in the pair, the target price for each stock (the one where it should revert to the mean) and volatility for each stock.

 

How to Implement the Pairs Trading Strategy?

The pairs trading strategy or statistic arbitrage is a market-neutral trading strategy that enables traders to profit from any market condition: uptrend, downtrend, or sideways movement. Hedge funds and proprietary trading desks have extensively used this strategy. This trading strategy aims to find two highly correlated instruments such that the correlation breaks down during specific periods and goes long on one instrument while simultaneously going short on another.

These pairs are often stocks and exchange-traded funds (ETFs) that have historically moved together. However, they can also be indices, commodities, or any assets that follow a particular pattern.

 

To implement pairs trading strategies, traders look for price convergence. This is a concept that says similar assets tend to move in tandem. So, if one asset moves up a lot, you should expect another asset that’s similar and closely related to follow along with that upward trajectory.  

How to Trade In Nifty & Bank Nifty?

Trading in Nifty and Bank Nifty is not recommended for novice traders. The reason is the volatility you observe in these two instruments, and the risk involved is very high, especially if you are looking at a 10-12 point move.

Traders can take short positions using the “buy above … sell below” strategy. However, this would work only if there is decent liquidity in the market. If we look at the intraday charts, we will see that there are no buyers or sellers at specific prices during the day. So your limit buy order may get stuck, and you will end up booking losses on un-wanted positions.

The best suggestion for trading in these instruments would be to take small trades with proper stop loss and target levels.

 

Related Article: What Is The Relation Between The Bank Nifty And The Nifty Charts?

Investing In Pair Trading Strategy

The pair trading attempts to capture the spread between two securities in the same sector or industry. It is a form of relative value investing that exploits historical relationships between securities. The pair trading strategy typically capitalizes on short-term deviations from a historical relationship rather than longer-term trends.

A pair trading strategy works well when markets are range bound and not trending but does not do well in strong uptrends or downtrends, as it will experience losses during these periods. Pair traders can make money when prices rise or fall and if prices remain stable (or move sideways).

Conclusion:

Pair trading makes sense when you think about it. Because stocks are driven by supply and demand, they don’t trade in isolation; they tend to be affected by other stocks and broader market conditions. This means we can’t accurately assess how well or poorly a stock has performed by looking at its price action; we need to compare it with other relevant stocks.

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