Pairs trading is a process to take trades on the opposite side of negatively correlated trading instruments. In FX, investors use several tools based on technical and fundamental systems where correlation works as an essential price direction.
Moreover, different financial markets like forex, stocks, and cryptocurrencies provide a potential hint about the market direction.
Pairs’ trading strategy will be profitable if you know how to take trades based on this method. The following section includes a complete strategy using the pairs trading method to give enough profit for a lifetime.
What is a pairs trading strategy?
When investors buy an asset, the ultimate target is to find the price above the buying level to get a profit. On the other hand, if the price comes down and moves below the buying level, it will incur a loss. Every trader wants to avoid the loss, but there is no way to eliminate the loss at all. However, hedging is a process where traders can limit their losses by taking trades on separate currency pairs in the opposite direction.
Pairs trading is a process to open a buy in one instrument and short in another. In this process, how much one pair is performing against another pair is the outcome. As a result, it might provide profits for both trades, or it might incur losses. Instead of focusing on the broader market, pair trading is a process to hedge the risk and limit losses to a certain level.
How to use pair trading in a trading strategy?
Pairs trading is not limited to the FX market. Investors can extend the earning potentiality by using pair trading between multiple financial markets.
Based on our analysis and observation, we can distinguish pairs trading in the following category.
Stock pair trading
It is a process to take trades in the stock market that are positively correlated. For example, during the Covid-19 pandemic, people remained at home, pushing them to use technical staff more than before. Therefore, if you have bought multiple tech giant stocks like Microsoft, Google, Apple, etc., together, it would be a sound pair trading system.
The above image shows the daily chart of Microsoft Stock [MFST] and Apple Stock [AAPL]. Both are positively correlated as they both moved higher with an intense buying pressure after the pandemic.
Therefore, investors can buy both of these stocks and perform pairs trading to boost the profit.
Index pairs trading
Index of a country represents that geographical area’s overall economic status that helps traders identify the market direction. Moreover, there are sector-based indices that show the performance of a group of listed companies. S&P 500, NASDAQ 100, CAC 40, etc., are examples of indexes.
In index pairs trading, investors can buy stocks from the same indices, where one top NASDAQ 100 company can influence the similar price direction for other companies.
Commodities pairs trading
There are thousands of trading instruments in commodities where finding positively correlated instruments are elementary. For example, we can combine some top traded commodities as follows:
- Gold and silver
- WTI crude and Brent crude
- Copper and nickel
A short-term strategy
In this section, we will see a short-term pairs trading method that applies to the FX market. The currency pairs are the most volatile instrument in the financial market, where widespread, a sharp movement during the new release.
Therefore, in this approach, we should find the top four FX fundamental indicators to show results. Once the news release opens the trade from the primary swings correction on correlated pairs.
Best time frames to use
As it is a short-term method, it is wise to open trades on five minutes chart.
Entry
Before opening a trade, make sure to follow these conditions:
- Strong news appeared with a considerable change.
- The market made an immediate move after the news release and corrected it.
- Open a buy/sell trade in similar currency pairs from the primary correction.
Stop loss
Stop loss is below or above the pre-news level.
Take profit
TP 1 is based on 1: 1, risk vs. reward ratio, and move the stop loss at breakeven. Later on, close the total trade after finding a solid price level.
A long-term strategy
Long-term pairs trading is a process to identify the broader market direction using multiple financial markets. For example, if the US stock market moves higher, it will positively affect the US Dollar. Moreover, the US Dollar index will work as a firm price director for the USD in any currency pair. Therefore, we will focus on index and currency pairs in this method to find a market direction.
Long-term trading is suitable for investors and HODLers it is better to apply it with the stock market. For example, if the S&P 500 is moving up, we will focus on buy setups in S&P 500 companies. The same theory applies to Dow Jones, NASDAQ 100, and other indices.
Best time frames to use
As it is a long-term method, we will focus on trading in the daily chart.
Entry
- Open a buy trade in stock once the associated indices are moving up.
- The stock was moving within an uptrend and corrected lower towards a support level.
- The buying entry is valid once the price rejects the support with a bullish daily candle.
Stop loss
The stop loss is based on technical price structure, below the rejection candlestick with some buffer.
Take profit
You can hold the trade for a long-time. Generally, the stock market needs time to provide a decent outcome. In that case, you might have to wait months to get the maximum benefit.
Now move to an example of the pairs trading strategy.
The above image shows the daily chart of the S&P 500. Therefore, we should focus on finding buy setups in the S&P 500 stocks.
In the above image, we can see that the Apple stock is trading above a critical support level where the price is very corrective. In this context, any bullish rejection with a daily close would be a substantial buying opportunity in this pair.
Pros and cons of trading strategy with pairs trading strategy
Let’s see the pros and cons of this trading method.
| Pros | Cons |
| A very profitable strategy where investors want to expand the portfolio in multiple sectors. | It needs extra attention to the broader market condition. |
| It is an excellent opportunity to hedge market risk. | A solid technical and fundamental knowledge is mandatory. |
| This method applies to any financial instrument. | Even if you follow this method, it would be hard to eliminate the market risk. |
Final thoughts
Pairs trading would be the following trading method that you should include in your basket. Having multiple proven trading methods often helps traders to fight uncertain market conditions. Besides, you can apply the pairs trading method as an additional confirmation to your existing trading method.
