Many a time, traders come across the term “risk-free trading”. Although in reality it is virtually impossible to trade a purely risk-free strategy, certain strategies can definitely fit the description of having less downside risk than others. Without a doubt, Pairs Trading falls into this category.

Pairs trading involves the idea of choosing two correlated financial products (or groups of products), figuring out what their historical correlation is, and making the assumption that this correlation will hold true in the future. Essentially, a trader is betting that more likely than not, this correlation should hold true in the future. A skilled trader with proper knowledge of position sizing can effectively apply the concepts of Pairs Trading into his/her day-trading strategies.

## The Benefits of Pairs Trading

Pairs Trading can be beneficial because it protects the trader from market wide sources of risk. A Pairs Trading strategy that is market neutral can protect the trader from market wide fluctuations. For example, if two stocks are highly correlated, a trader can sell the outperforming stock and purchase the under-performing stock. If the trader holds on to the belief that their relative correlation will come back to normal, then he/she is hedged against market wide movements; eventually, when the stocks regain their historical proportion/correlation, the trader can square off his/her two positions and earn a profit.

Here is a basic example. Here are the daily closing prices of Reliance Industries (NSE:RELIANCE) and Essar Oil (NSE:ESSAROIL) for the past 7 trading days:

RELIANCEESSAROILRatio
765.3563.3512.08
771.264.411.98
765.8564.8511.81
773.7566.0511.71
773.6568.2511.34
786.868.211.54
798.369.811.44
Correlation87.21%

The correlation can be calculated easily in Microsoft Excel by using the CORREL function.

Since the two products seem to be highly correlated, a trader can look make the judgement that the ratio between the two products should be between 11 and 13. Assume that the next day, the trader notices Reliance trading at 800, while EssarOil is trading at 73. The trader calculates that the ratio between the two products is less than 11 (800/73 = 10.95). Therefore, it seems that this is a good opportunity to get into a trade. In this example, the trader would sell EssarOil and buy Reliance since Reliance is relatively under-performing and EssarOil is relatively over-performing.  Since the ratio is approximately 11, the trader would sell 11 shares of EssarOil for every share of Reliance that he purchases.

At this point, the trader’s true test arises: when should he/she exit the trade? Patience can be the most difficult aspect of trading! Eventually, the trader is looking to exit the trade once the ratio stabilizes to above 11 and the trader can earn a profit. It is generally a good idea to set yourself a profit objective (and if possible, a stop loss) when entering a trade. In our example, the trader might set the profit objective to be a ratio between the two products. Since the trader felt that 13 was relatively high ratio between the two products, he/she can set 13 as the ratio the products must hit in order for him to exit the trade.

Eventually, the trader notices Reliance is trading at 760 and EssarOil is trading at 58.45. The ratio has breached 13! The trader immediately sells Reliance and purchases EssarOil.

If he/she had executed 110 shares of EssarOil and 10 shares of Reliance, his/her net profit (before costs) would have been:

EssarOil: (73-58.45) x 110 = Rs. 1600. 50 profit

Reliance: (760-800) x 10 =  Rs. 400 loss

Net: Rs. 1200.50 profit

As you can see, although the market had dropped between his two series of transactions (both Reliance and EssarOil fell in price), the trader was able to earn a profit by hedging his trades. This is the power of Pairs Trading!

## Getting Started

Pairs trading, in its simplest form, can be done by calculating the correlation between any two single financial instruments. Similar to the above example, a trader can use the same exact concept to do Pairs Trading on Cash-Futures arbitrage. This is where you would pit the near month futures product of a security against its Cash underlying.

There are a few important concepts to remember if you want to implement a Pairs Trading strategy.

1. Ensure that it makes intuitive sense for the two products to be correlated! For example, a trader might notice that a Nifty Call Option seems to be highly correlated with USD/INR January Futures by plugging in the data and calculating the correlation. However, just because the data shows a correlation does not mean that there is a cause for the correlation! As the old adage goes, “correlation does not imply causation!”
2. Use a high sample size to calculate the correlation. In the earlier example, we used only 7 days worth of data for calculating the correlation between Reliance Cash and EssarOil Cash; a knowledgeable trader should look to ensure that the stocks have had a steady, consistent correlation for many months before making his/her trading decisions.
3. Use proper position sizing! In our previous example we executed 11 shares of EssarOil for every share of Reliance. In general, it is wise to ensure that the market value of the two transactions is as close as possible.
4. Use profit objectives and stop losses. After entering a trade, implement a mental stop loss and profit objective; this keeps the guesswork out of the game and allows you to trade emotion-free. The profit objective and/or stop loss can be hard prices or based on ratios.

## Conclusion

In conclusion, Pairs Trading can be a highly effective way for you to hedge your risks while trading. It does a good job at eliminating market-wide risk that allows you to remain market neutral. While you probably will not earn a large amount on any one trade, your downside risk is also minimized which gives you peace of mind. If you are willing to do some homework, implement proper position sizing, and are able to remain patient, Pairs Trading can be an effective way for you to hedge your risks in all types of different market conditions.

• ANAND

Great article. Please can you give few more examples? Is it also works for nifty option Trading? If yes, please explain. Or else please provide mail I’d I will contact you. Great….

• Hi Anand,

Pairs Trading is usually done on Equities but can also be done on Futures and Options. We will have more articles on trading strategies for Futures and Options in the future!

• Anand

In your example, if its other way like reliance rise more than essar oil, then what will be the buying and selling quantity?

• Hi Anand,

The idea is to keep the market value of both trades the same. Therefore, even if you are selling Reliance and buying Essar Oil, you would use the appropriate quantities to ensure that the (Qty x Price) of Reliance is equal (or at least, as close as possible) to (Qty x Price) of Essar Oil. Hope that helps!

• shashank

good one sir, but did u really made money out of this..??

and sir can we do hedging in currency market also.
with out knowing in which may market will head..

• Hi Shashank

Yes, you can definitely earn from pairs trading!

Yes, you can also do pairs trading in currencies! But it’s not as common as other segments. You can try to apply to same concepts as see what you come up with!

• YOGESH MAHLA .

Hi
In Currency spot trading(spread trading) there exists a very high negative correlation between EURUSD and USDCHF during daily and Weekly time frames.

• Hi Yogesh,

Generally speaking, you will see a inverse correlation between two pairs if USD is the base currency of one (USDCHF) and quote currency of the other (EURUSD).

• SWETHA

Excellent article. Please can you give few more examples? Is it also works for nifty option Trading? If yes, please explain. Or else please provide mail I’d I will contact you. Great…. please waiting for ur feedback bcoa we r doing only option Trading.

• Hi Swetha

We will be updating the blog with new posts on Pair Trading in the future- stay tuned! Until then, I would suggest reading up on Pair Trading and trying it out for yourself!

Great Idea !

• Thanks Amarnath!

• soham Gupta

Dear All….. here if anybody have any link about ” PAIR TREADING” plz. send me to my email id:sohom_gpt08@yahoo.in
Thank You.

Great article on pairs trading strategy. Keep it up

• Thanks! We will be following up with a Part 2 article soon! 🙂

• sunil

Dear Raghu,

My furst question, how would one identify 2 stocks for Pair Trading???
It will be highly impossible to check all the stocks corelation and then go ahead…

Regards,
Sunil.

• Dear Sunil,

That’s a great question. A quick and dirty way is to ensure that both stocks are in the same sector. Then, you can go and see exactly what it is that each company produces: if it makes sense for them to be correlated (for example, two pharmaceutical companies that produce similar and competitive products), then chances are that they should be correlated. From there, you should check the actual historical correlation for confirmation.

Hope that helps 🙂

• Sunil

Dear Raghu,
Having answered my first question… i have another for you. Infact a series of questions to understand completely the Pairs Trading strategy.
Hope it will not bother you.

My Question : In the process of finding pairs, i have come acrossa problem. What should be the Correlation comparision timeframe? 5 days, 1 month, 6 months??? I have different corelation when i have different timefram,es (understandably correct)… but while i have them differed by a good margin, how should i beleive them to be corelated?.

Also, can you please provide some books (by indian authors) on this subject for further reading.

Thanks a lot Rahu in advance.

Regards,
Sunil

• Sutirtha Santra

Sir,
I want to know how can i trade in option with pair trading strategy as there time value is factor ?

• Sutirtha Santra

Sir,
Is it is possible to pair trade with stock option ?Please send me a mail as i could not remain for a long time on this blog because most of the time i remain out side of my office.

• p.kailash

sir
can i buy both nifty call and put option of the same premium same strike price one day of the election result 2014 how far this will work sir pl let me know

• Hello Sir,

Sorry, I was not able to understand the question. Could you try rewording the question?

Thank you.

• JM

How do you determine which asset is under-performing and which is over-performing? That makes a difference when determining which to short and which to long. Thanks.

• mukesh bhatia

Hello,

I am looking for most correlated Indian stocks(NSE) in all these time frames 5 min, 30 min, 1 hour, 1 day, 1 week, 1 month, 3 month, 6 month, 1 year

If I compare two stocks in the excel/on the page, I should be able to see their correlation in all of the above time frames…

Can you make such an a webpage please…if yes I will visit your website everyday and click lot of advts for you

Or can you make such an excel for me if yes how much charges for that

Regards,
Mukesh