It is often difficult to close a trade that is losing a modest sum but has expired as the inclination is to opt to "give it a few days" in the hopes that the break-even level can be restored. When these profitable divergences occur it is time to take a long position in the underperformer and a short position in the overachiever. Not your trade opening time. For each stock pair, the relative performance of each stock is measured from the time you purchased the option.
Pair Options are Unique and Offer Significant Benefits to Pair Trading investors:
The goal is to match two trading vehicles that are highly correlated, trading one long and the other short when the pair's price ratio diverges "x" number of standard deviations - "x" is optimized using historical data. If the pair reverts to its mean trend, a profit is made on one or both of the positions.
An Example Using Stocks Traders can use either fundamental or technical data to construct a pairs trading style. The first step in designing a pairs trade is finding two stocks that are highly correlated. Usually that means that the businesses are in the same industry or sub-sector, but not always.
This simple price plot of the two indices demonstrates their correlation:. For our example, we will look at two businesses that are highly correlated: Since both are American auto manufacturers, their stocks tend to move together. Below is a weekly chart of the price ratio between Ford and GM calculated by dividing Ford's stock price by GM's stock price.
This price ratio is sometimes called "relative performance" not to be confused with the relative strength index , something completely different. The center white line represents the mean price ratio over the past two years. The yellow and red lines represent one and two standard deviations from the mean ratio, respectively.
In the chart below, the potential for profit can be identified when the price ratio hits its first or second deviation. When these profitable divergences occur it is time to take a long position in the underperformer and a short position in the overachiever. The revenue from the short sale can help cover the cost of the long position, making the pairs trade inexpensive to put on.
As with all investments, there is a risk that the trades could move into the red, so it is important to determine optimized stop-loss points before implementing the pairs trade. An Example Using Futures Contracts The pairs trading strategy works not only with stocks but also with currencies, commodities and even options. In the futures market , "mini" contracts - smaller-sized contracts that represent a fraction of the value of the full-size position - enable smaller investors to trade in futures.
A pairs trade in the futures market might involve an arbitrage between the futures contract and the cash position of a given index. When the futures contract gets ahead of the cash position, a trader might try to profit by shorting the future and going long in the index tracking stock, expecting them to come together at some point. Often the moves between an index or commodity and its futures contract are so tight that profits are left only for the fastest of traders - often using computers to automatically execute enormous positions at the blink of an eye.
An Example Using Options Option traders use calls and puts to hedge risks and exploit volatility or the lack thereof. A call is a commitment by the writer to sell shares of a stock at a given price sometime in the future. A put is a commitment by the writer to buy shares at a given price sometime in the future.
Instead, they attempt to make profits on relatively stable low volatility duration and compensate with high volume trades.
Traders can also take long-term positions, which can last from days to several weeks; forex trading is very accommodating in this way. Offers Very High Liquidity: Compared with any other financial markets , the forex market has the largest number of market participants.
This provides highest level of liquidity, which means even large orders of currency trades are easily filled efficiently without any large price deviations. This eliminates the possibility of price manipulation and price anomalies , thereby enabling tighter spreads that lead to more efficient pricing. One need not worry about the high volatility during opening and closing hours, or stagnant price ranges during the afternoons, which are trademarks of equity markets.
Unless major events are expected, one can observe similar price patterns of high, mid or low volatility throughout the non-stop trading. Being an over-the-counter market operating across the globe, there is no central exchange or regulator for the forex market. Most such developments are already perceived and priced into the market. Such a decentralized and deregulated market helps avoid any sudden surprises. Compare that to equity markets, where a company can suddenly declare a dividend or report huge losses, leading to huge price changes.
In addition, the chances of insider trading are almost nil especially on major currency pairs , as there are no insiders in the forex market, which is dependent on global factors and perceived developments. The major currencies frequently display high price swings. If trades are placed wisely, high volatility assists in enormous profit making opportunities.
Variety Of Pairs To Trade: There are 28 major currency pairs involving eight major currencies. Criteria for choosing a pair can be convenient timing, volatility patterns, or economic developments. A forex trader who loves volatility can easily switch from one currency pair to the other. Top 8 Most Tradable Currencies.
Due to tight spreads in terms of pips , one can easily start forex trading with a small amount of initial capital. Without more capital, it may not be possible to trade in other markets like equity, futures or options. Availability of margin trading with high leverage factor up to to-1 comes as the icing on the cake for forex trades. While trading on such high margins comes with its own risks, it also makes it easier to get better profit potential with limited capital.
There are hundreds of forex technical indicators to draw on for short-term trades, and several fundamental analysis theories and tools for long-term forex trading, creating enormous choice for traders with varying levels of experiences to make a swift entry into forex trading.
Cons Lack of Transparency: Due to the deregulated nature of the forex market dominated by brokers, one actually trades against professionals. Being broker-driven means that the forex market may not be fully transparent. A trader may not have any control on how his trade order gets fulfilled, may not get the best price, or may get limited views on trading quotes as provided only by his selected broker.