Eliminating Market Risk With Pairs Trading
Whether you’re just getting started on your trading journey, or have been trading for some time, you’ve probably noticed that lots of markets move together. This phenomena is known as correlation. Correlations exist because individual markets share similar or identical fundamental drivers. For example, a rise in the price of milk at the farmgate is likely to boost dairy stocks, or a rise in US yields will usually lead to sell offs on AUDUSD, NZDUSD, EURUSD, GBPUSD etc.
The thing about correlations though, is they don’t always remain static. The strength of correlations between different assets tends to wax and wane over time. Pairs trading is the art of exploiting the shifting relationships between correlated assets, simultaneously buying and selling two highly correlated assets in an attempt to eliminate market risk.
In this piece we will introduce two distinct styles of pairs trading and discuss the pros and cons of each approach.
Convergence, or mean reversion trading, is a strategy that seeks to capitalize on temporary inefficiencies in highly correlated markets. Actually, convergence traders don’t just look for highly correlated markets, they look for a phenomena known as cointegration; markets that usually match each other point for point. The convergence trader assumes any weakening of correlations is temporary and the relationship will soon return to normal (revert to the mean).
ABC and XYZ are US Banking stocks which usually move together in lock-step. A convergence trader notices ABC is outperforming XYZ and sees a potential to exploit this temporary divergence. The trader opens a short position on ABC and a long position on XYZ, assuming XYZ will soon catch up. Some good news comes out for the US banking sector and both stocks rally, but as ABC is already relatively overbought, XYZ rallies harder. The traders short position on ABC is now down 75 points, but his long position on XYZ is up 100 points. The relationship between the two stocks has reverted to the mean and the convergence trader closes both positions for a net profit of 25 points.
Convergence trading cointegrated markets can be an extremely reliable and profitable strategy. Hedge funds will often run algorithms that exploit temporary divergences throughout the day and some of these firms can go hundreds of days without a loss. On the other hand, the nuts and bolts of a mean reversion trading strategy are extremely technical, and a lot of data crunching is needed to identify cointegrated markets. Though this approach is market-neutral, there is a risk that the “temporary” divergence you seek to capitalize on is actually a shift in paradigm, that is, the relationship between the two markets is broken.
Divergence, or strong vs weak trading, is another market-neutral pairs trading strategy which is arguably more accessible to your average trader. All that is required is two highly correlated markets. While a convergence trader assumes any divergence is temporary, a divergence trader sees good reason for this divergence and assumes it will continue for long enough for them to turn a profit.
AUDUSD and NZDUSD are two highly correlated currency pairs, though they don’t always move together in unison; if one finishes the day higher, the other one usually will two. The RBA has hinted that they will be looking to raise rates in the near future and as the RBNZ has been relatively dovish, AUDUSD has been outperforming NZDUSD. The divergence trader understands why the Australian Dollar has been outperforming and thinks this will continue for some time, so he opens a long position. On the other hand, the trader is worried about market wide sentiment and sees an opportunity to hedge this risk via a short on NZDUSD. A few days later, a large investment bank in Europe defaults and sends markets into a tailspin. Though the trader is down 100 pips on his AUDUSD long, NZDUSD is hit much harder as there are no rate hikes on the table and falls 150 pips. The trader closes both positions for a net-profit of 50 pips and awaits another buying opportunity on AUDUSD.
Divergence trading is great way of eliminating market risk in your trading. As the two markets only need to be highly correlated and not cointegrated, this approach requires very little research and zero data mining. Divergence trading allows you to capitalize on fundamental trading opportunities, whilst hedging your bets against market wide risk events. On the other hand, the divergence you are looking to trade may be short-lived and could dissipate before you are able to turn a profit.