Pair trading is an investment strategy which involves buying stocks in companies that are very similar. There is usually a correlation in the price of stocks, which means that they move up and down together.
For example, if Company A’s stock price decreases because it loses a contract. In such, Company B is likely to have its stock price decrease as well. Pair trading has the benefit of diversifying investment risks while still maintaining consistency within a portfolio. It’s easy to learn how to pair trade through these 8 steps!
Is pair trading the best option for you?
While pair trading may seem like a great way to increase the return on investment, doing so without knowing what you’re doing could cause losses to spiral out of control. One of the most important things to keep in mind when deciding whether or not to use pair trading is that it can be a risky strategy.
There are three main strategies when it comes to pair trading:
- Long and Short Pairs: This is the classic strategy, and involves long and short position pairs in which one component is required for the other component. For example, Company A and Company B may be involved in order for business development activities. Company A is your short position, while Company B is your long position. You then wait for the two prices to move in the same direction, and profit from the difference.
- Long Pairs: This involves using one pair of stocks which you believe are correlated, but for which you have no intention of hedging your risk.
- Short Pairs: In this, you use one pair of stocks which you believe are correlated, hedging your risk by taking out a short position in one stock based on an anticipated movement related to the other stock.
Step-By-Step Guide to pair trading
It’s important to consider how much time and effort you’re willing to put into this strategy.
The first step includes creating an account with a brokerage service provider such as Trading 212 or eToro, both platforms offer free demo accounts so you can practice before opening your own live account.
- Step 2 is to set up a trading model. Your trading model will include the stock pairs that you wish to buy, your budget, and your stop-loss limit.
- Step 3 includes depositing money into your brokerage account. Once deposited, use that cash to open positions in the stock pairs that you’ve selected for your trading model.
- Step 4 is to monitor each stock pair’s performance on a daily basis. Just use the effective technical indicators such as the RSI, MACD and Bollinger Bands. Also, you can consider the fundamental factors such as earnings reports and news announcements.. This step will help you understand what is causing each stock pair to move up or down in price.
- Step 5 is to exit a position. You do this when the stock pair has reached the stop-loss limit previously established for it. This step will help you avoid incurring large losses due to malicious trades.
- Step 6 is to re-balance your portfolio. This involves selling off any of the profitable stock pairs and using those profits to invest in any underperforming or losing stocks. In this way, your portfolio will maintain a high degree of consistency even as it experiences growth.
- Step 7 involves using the profits that you’ve earned to reinvest in your trading model. This will ensure that you keep growing your portfolio, which will ultimately help you reach financial independence within a shorter time period.
- You can also use any profits that you generate to make withdrawals from your account, but be careful not to make these withdrawals too quickly! If you do, then it could affect how much your invested capital gains over time.
- Step 8 is to continue implementing the other steps until your account reaches a steady state of high profitability. Remember that each investor should create their own trading model based on their risks, rewards and capabilities. Of course, you can use the steps that I’ve created. However, it is very important that you understand that pair trading is an approach that differs from person to person; this means that there is no one-size-fits-all strategy for everyone.
Most people think of pair trading as a way to invest in stocks, but you can also use it for investing in other financial instruments such as gold or bonds. Just remember, always stay on the lookout for new investment opportunities!
Pair trading is a riskier approach to investing, but it can be a beneficial investment strategy. It’s important to understand how this strategy works before you begin using it, so use the steps outlined above as a guide.
To learn more about the steps involved in pair trading, you can refer to this post: