The risk to this type of pairs trade, however, is that sometimes the relationship may be altered by outside forces. For example, West Texas and Brent Crude Oil have always traded at fairly similar prices. In early 2011, however, the Arab Spring raised the risk premium on Brent Crude Oil and opened up a significant gap between the two prices that remained for an extended https://trading-market.org/ period of time. This makes pairs trading particularly unpredictable within a volatile market such as the commodity market, as something like the weather can have an adverse effect on your positions. Both internal and external factors can have an effect on not only financial securities themselves, but also the companies that are in charge of supply and demand.

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It is defined as scenarios where you take profit before the prices move in the other direction. For instance, say you are LONG on the spread, that is, you have bought stock A and sold stock B as per the definition of spread in the article. We performed such test to all pairs and select at least one pair in each cluster to diversity our portfolio. Then, a strategy that observed based on the movement of the spread can be designed and executed well in the later part. It works by dividing the data into several training and validation sets, and then walks through these sets by optimizing for the best values on the training sets.

One of the more obvious relationships is between the S&P 500 index (SPX) and the Dow Jones Industrial Average ($DJI) because they generally move in the same direction. Because more than 40% of harvested corn is pegged for ethanol production. Meanwhile, corn futures and soybean meal futures compete as substitutes to nourish cattle.

## Unlocking Profit: Building a Winning Pair Trading Strategy in Python

The key challenges are to find a good pair for trading, optimal entry/exit and a stop loss as an additional risk management component. It goes into more detail about which asset types work best, different methods to assign weights to your pairs, and also discusses certain things to avoid to help you in your strategy creation. We will be checking the last 20 days to see what the maximum divergence has been over that period. A nice feature of the Alpaca library is that it will automatically attach a Pandas DataFrame to the object that’s returned when we query for historical data. Before getting started, we should note that this pair’s trade example is for educational purposes. We don’t recommend that you run this strategy in a live environment.

- Calculate ‘n’ using regression so that spread is as close to 0 as possible.
- To increase the odds of success, track relationships over time, identify price divergences, and hypothesize when they may come back in line.
- We then add the historical prices of the stock to the prices DataFrame.
- This can be achieved by calculating the daily percentage change and then using cumprod() to get the cumulative returns.
- It is a form of arbitrage called statistical arbitrage, or stat arb for short.

Next, we create a portfolio data frame that will store the portfolio values for each day. We initialize it with zeros for the shares of each stock and cash. We also set the initial value of the portfolio to a fixed amount, in this case, $1000. Next, we create another empty Pandas DataFrame called returns to store the daily returns of the ten stocks. We loop through each ticker in the list again, calculate the daily returns of the stock using the log return formula and add the daily returns to the returns DataFrame.

## PAIRS TRADING IN VARIOUS MARKETS

The gain on the short silver position would be partly offset by the loss on the long gold position, leaving you with a 2% net gain. One can often pairs trade similar commodities in order to take advantage of changes in relative outperformance or volatility, such as crude oil vs natural gas or gold vs silver. You also can trade different types https://investmentsanalysis.info/ of the same commodity such as crude oil from the US (West Texas) versus the UK (Brent). Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Please read Characteristics and Risks of Standardized Options before investing in options.

- You’ll need confidence, experience, and a large account with futures trading approval.
- If Asset X is twice as volatile as Asset Y, you can trade 2 units to 1 unit.
- To identify these points, a statistical construct called z-score is used.
- Sometimes even a single Pair trade requires a Pair trader to pay a commission which is nearly double the amount of the commission required in the standard trade.
- We also set the initial value of the portfolio to a fixed amount, in this case, $1000.

The value of +1 means there exists a perfect positive correlation between the two variables, -1 means there is a perfect negative correlation and 0 means there is no correlation.

## Understanding Pairs Trade

The idea is to assume future convergence of the related stocks’ prices. Not all of them are satisfying and, rather, some even would suffer significant losses over the testing period. We searched through possible action threshold pairs to find the optimal performance upon testing.

Learn how to apply a pairs trading strategy effectively in this guide. Thanks to market neutrality, this trading strategy can be very safe (if diversified) and immune to global market crisis, even when the entire market or sector falls down. If you trade enough pairs at the same time, your pair trading portfolio could perform well also in difficult market situations. The approach proposed by Avellaneda https://day-trading.info/ and Lee (2010) uses PCA to create a seemingly mean-reverted spread which in turn is modeled by an OU-process. This model, at the time of writing, is considered by many to be the cutting edge of mean reversion trading. This is an advanced pairs trading strategy that relies on using stochastic processes to generate the optimal trading rules and policies for mean reverting portfolios.

## Reliance of the High Statistical Correlation

With this distribution we can create threshold levels such as 2 sigma, 3 sigma, and so on. For our strategy we don’t want to look at the correlation alone but at co-integration as well. The co-integration test identifies scenarios where two non-stationary time series are integrated together in a way that they cannot deviate from equilibrium in the long term. If you have two stocks that move similarly, but one stock consistently outperforms the other as an example, the weighting can be adjusted to manipulate the spread into a stationary time-series. In our example, we know that the average deviation in the spread is a bit under 2%. Before entering into a trade, we need to determine the correct position size for each asset and also calculate our take profit and stop loss.

Pairs traders use some type of analysis methodology to confirm the trade and help customize the buy and sell rules. An overlay analysis will help adjust profit objectives and stop loss levels according to the specifics of a given trade. There are many different types of technical and fundamental overlays that can be employed, from candlestick charting to relative strength. This is the most difficult and time-consuming step in the process. It includes selecting a trading universe, constructing and testing a model, if one is to be used, and creating general buy and sell guidelines. An individual trader’s resources and expected trade duration will affect each of these factors, but the structure is functionally the same in all cases.

Pairs trading is a form of short-term statistical arbitrage, which is a strategy that relies on mean reversion to hold positions and securities for a short period of time. This strategy could be applied to financial markets including shares, indices and commodities. Pepsi (PEP) and Coca-Cola (KO) are different companies that create a similar product, soda pop. Historically, the two companies have shared similar dips and highs, depending on the soda pop market.

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The pairs trading strategy uses statistical and technical analysis to seek out potential market-neutral profits. One major risk in pairs trading is that you could get squeeze if both sides of the trade go the other way. Suppose gold falls by 8% and silver climbs by 10%, the 8% loss on the gold position coupled with the 10% loss on the silver position would hand you an 18% loss on the pairs trade. Pairs trading strategies are usually meant to be short to medium term at the longest. Even the most highly correlated names tend to lose correlation over time.

## OTHER APPROACHES

The strategy shows consistent alpha for in-sample and out-of-sample backtests. Nevertheless, we have chosen a more conservative approach with a risk of 4% per trade since the risk of ruin is on average only 1.8% when combining both data sets – training data and validation data. If you’re looking for tips on designing your pairs trading strategy, the following link has a lot of useful information- Pairs Trading – A Real-World Guide. When positioning in a pairs trade, both sides of the trade should be equally weighted in dollars. If both assets had the same price that would be straight-forward. Another thing to be mindful of is that pairs trading can provide a false sense of security.

The trader bets that a $50 stock and a $55 stock, for instance, will either have a larger or smaller spread ($5 in this case) when the trade is closed. Divergence traders will like to see the spread increase while convergence traders will prefer to see the spread decrease. The best advantage of pairs trading is that the trader is completely hedged.