When traders look forward to trade in pairs, they try and search for certain commodities and stocks that have things in common, like price, etc. This is because the trading history justifies that if one stock goes up, the other will tend to decrease in terms of pricing. This is how the traders capitalize on the situation. They try to long with the stocks that they believe will increase price in the future. Similarly, they tend to avoid stocks that will fall in pricing in the near future.
The problem with pair trading is that the traders don’t feel like waiting. It might seem, that the trading is not in their favor in the initial time. But, a little patience will definitely turn the tables in their favor. Traditionally, it might seem that the stock you are confident with is not performing well, while the other one is. But it is only a passage of time before the stocks switch places.
How does trading in pairs operate?
Trading in pairs often leads to the markets being neutral. This is because if the stocks are moving in a similar pattern in the past, they will continue moving in the same direction. Assuming that the markets will turn back into neutral in the future, stocks are traded in relation to this. A stock performing poor currently will surely turn back to good form in the near future. Similarly, if a stock is performing excellently currently, it will return to its neutral performance soon, indicating a price increment.
How can trading in pairs eliminate risk?
The question that people come across is why do traders prefer trading in pairs? Does it really have a significant impact to the trading patterns? Well, it does. It is indeed a very profitable technique to reduce the risk. The best benefit that traders can enjoy with pair trading is that the element of fair markets can be taken care of with ease. And traders can violate conditions making sure they turn the tables in their favor.
Can the traders benefit if only one stock moves in their favor?
Yes, they can. Even if one of the stock does not act in accordance to your prediction, chances are you can still succeed. If the price of the poorly performing stock increases in a greater proportion that the price decrease of the better performing stock, traders can record a significant profit through it. It might look like a loss in the shorter run, but it is a win win situation in the longer run.
How to find correlated stocks?
Once you have decided to trade in pairs, the next obstacle that one comes across is to find the correlated stocks amongst the list of stocks. This is arguably the most important element to pair trading as messing this up can lead to serious consequences. Before you start trading on stocks, it is important to understand what correlated stocks are.
Correlated stocks can be defined as those stocks that move in sync, i.e. if one goes up, the other goes down, and vice versa. They have a correlated of 1. Since it is impossible to find stocks that are perfectly correlated, traders tend to settle for certain stocks that are closely related. For example, stocks having coefficient of 0.7, 0.8 are also looked forward to.
One of the important things after assessing the correlating stocks is to identify their reason of relation. You just cannot rule out two stocks if they don’t have no connection between. Stocks from the same industry or competitors stocks can be seen as a good chance of having some essence of correlation amongst them. You can find more information on GBP-USD Trading online by visiting our website.
How to see if the correlation is real?
Once you have found the perfect correlation, it important that you test it before trying out something. Correlation cannot necessarily occur is similar patterns and hence you will need to test its history sufficiently. You might not always find a perfect relation which is why testing is necessary. This is where the knowledge and experience of the trader comes in to play. Once you have carried out backward and forward test, you can start off with trading in pairs.