Pair Trading Can Reduce Risk In Both Stocks And Forex Trading

What is pair trading? If you haven't done pair trading before, pair trading is done with two almost similar stocks. Pair trading is highly popular with professional stock traders when they take simultaneously a long position in one stock and a short position in another almost similar stock in equal dollar amounts. Both these stocks are almost similar but are experiencing a dislocation. This dislocation in these two stocks is used for hedging purposes.

What you do is try to find two stocks in the same industry and the same sector with a strong historical correlation between them. Yet for the time being, these two stocks are experiencing dislocation with one stock higher in price as compared to the other stock. Overtime, both the stocks are going to converge to the same price level.

So you spot a dislocation between two almost similar stocks. Now you benefit from this dislocation by going long on the lower priced stock and short on the higher priced stocks. Since the lower priced stock is supposed to go high in price and the higher priced stock is supposed to go down in price if the convergence is going to take place. So when both converge, you make a nice profit. And if they don't converge, you don't lost much as both are going to move simultaneously in the same direction so your loss is not going to be significant. This is the essence of pair trading. You profit from the tendency in almost similar stocks to converge to their historical relationship.

Pair trading can be used in currency trading as well. The good thing in currency trading is the fact that you don't have to buy two currencies. In currency trading , you deal with a currency pair. Currency prices are always relative. So you can't talk about the absolute price of US Dollar (USD). You talk of USD price relative to British Pound (GBP) or Euro. So when you buy a currency pair, you go long on one and short on another. So pair trading is already inherent in currency trading unlike in stock trading where you have to buy two stocks separately.

When you do pair trading, you strip out the influence of the market on the two securities as both the securities have strong correlations and the market effect cancels when both the securities move as you are long on one and short on another.

Currencies can also be viewed as stocks with countries replacing companies. Just like companies are affected by the broader economic fundamentals in the same way countries get affected by sovereign debt, trade protectionism, trade balance, budge deficit and so on. These things affect the respective currencies. Now two countries in the same region with strong trade and economic relationship can have their currencies behave in almost similar fashion. This is the basis of pair trading in forex.

Japanese Yen (JPY) was a popular carry trading currency. Traders were happy selling JPY and buying another high yielding currency like AUD. But in 2009, carry traders lost their risk appetite and suddenly started unwinding their yen positions. This massive buying back of JPY made JPY appreciate. So this appreciation of JPY is short term.

Korean economy is closely tied to the Japanese economy with its Won doing well but you can profit from this short term divergence in JPY and Won by trading the pair JPYKRW. Similarly you can pair trade Euro and Pound!