When trading on the differential movement of two securities, you either speculate that they will narrow (convergence) or wide (divergence). The reason is that the disparity in value may sometimes widen further – outside historical boundaries – causing losses to the pair trade. When the entry point is found, the trader makes two deals, the rising asset is sold, and the falling asset is bought. Therefore, you should not dwell on one pair of assets for a long time; you must constantly search for pairs suitable for statistical trading. We only need the last 2 lines of our data_df DataFrame that show yesterday’s closing price and the current prices. If the current absolute spread is larger than the maximum divergence determined earlier on, we can enter into a trade.

  • If the securities return to their historical correlation, a profit is made from the convergence of the prices.
  • We will empty our positions when the spread is below 0.5 (positive or negative).
  • If you understand the relationship, you may be in a better position to judge when and why the spread might break down.

We will place orders on the weights depending on trading signal and a constant. Looking at trading_signal and place_order python functions everything in the paragraph becomes clear. • Since it involves short selling, it may need margin and leverage, which can make gains and losses bigger, increasing the overall risk profile. And instead of using relative ratio traders may choose the more sophisticated cointegration model to model the spreads between two securities.

Lastly, if the strategy takes a trade, we will monitor it to determine when to exit. Thomas DeMichele has been working in the cryptocurrency information space since 2015 when CryptocurrencyFacts.com was created. He has contributed to MakerDAO, Alpha Bot (the number one crypto bot on Discord),…

What is the purpose of crypto trading pairs?

Crypto exchanges have responded to the huge demand for supporting as many pairs of cryptocurrencies as possible. Traders and investors use pair trading to leverage market inefficiencies. It can be a valuable tool for traders looking to diversify their portfolios and mitigate risks in the market. This blog delves deeper into the world of pair trading meaning, exploring its benefits, challenges, and strategies for success.

  • Arguably the most arduous and critical step within the pairs trading strategy is the process of choosing the pair to trade.
  • Furthermore, Ethereum (ETH) is the third most common asset and is present in 19.41% of pairs.
  • You need to do this calculation for each day in the time period that you are measuring.

Currency pairs are the national currencies from two countries coupled for trading on the foreign exchange (FX) marketplace. Both currencies will have exchange rates on which the trade will have its position basis. All trading within the forex market, whether selling, buying, or trading, will take place through currency pairs. To help forex trading profit you better understand trading pairs, consider the example below. A fiat-based pair works the same as a cryptocurrency-based pair, except one of the assets being exchanged is a fiat currency (AKA dollars or cash). Probably the best example of what not to do with a pairs trading strategy is the Long Term Capital Management meltdown.

Advantages of pairs trading

Market-neutral trading strategies intend to avoid substantial losses. Accordingly, one position can counterbalance the other and minimize the effects of poor stock selections. Hedge funds often employ market-neutral trading strategies to generate steady returns in all market conditions. They rely on specific convergences in the prices of two assets as a way of hedging against general market risk. In practice, I use statistical tests such as CADF and Johansen to help find potential hedge ratios for price series that I think have a good chance of generating a profit in a pairs trading strategy.

Close the trade

It can also be referred to as market neutral or statistical arbitrage. You must establish the spread range to identify the trade’s potential entry and exit points. This is done by looking at the range within which the ratio has fluctuated in the past. When the ratio moves past the expected range, it indicates a good opportunity for opening a trade. If the ratio indicates that one of the trading pairs is overvalued compared to the other, buy the undervalued cryptocurrency and short-sell the overvalued one.

Then, traders may even leverage the trade by borrowing shares on both buys and sells (or spreadbet via CFDs). The only question is how does each security move against one another during the bull and bear phase. If we can find out more about their characteristics, then we can design an appropriate pairs trade strategy.

Why shouldn’t I run a pairs trading strategy?

Pairs trading requires a robust methodology and a firm understanding of data analysis. If the Pepsi stock price increases and the Coca-Cola stock price decreases, we could create a long position on Coca-Cola and a short position on Pepsi. When the price of Pepsi stock goes down, and the price of Coca-Cola stock goes up, a successful pair trading strategy would yield better returns than only making one of those bets. Brokers need a margin account because stocks can, theoretically, rise forever.

DEALS for Free BTC, High APY, and Trading Fee Discounts

If not, it will break out and restart from the top and go to sleep until the next market open. There is also a quick check here to maxitrade information about the broker – broker overview see if the market is still open. If the market is closed, we can break out of this part and return to the start of the main loop.

How do we size our trades?

Also, liquidity provision comes with technical risks as DeFi liquidity pools rely on smart contracts. Plus, user error is commonplace due to the technical nature of interacting with public blockchain correct use for angular protocols. In most cases, if a short position loses a predetermined amount of money, the broker could force you to close the position or add more money to your account to cover your losses.

This is done by simply dividing the price of one crypto by the other on the pair, for example, ETH/BNB. This ratio is a representation of the relative value between the two assets. Coupling the inflation in the price of one asset with the deflation of another can reduce downside risk when trading.

This strategy assumes that the ratio will return to its historical average. Therefore, traders close their positions when the ratio moves back to this mean by selling the undervalued cryptocurrency and buying back the overvalued one, thus making a profit. Since the two stocks have been highly correlated in the past, they may begin trading in the same direction soon. In this example, you would take a long position in Stock A and a short position in Stock B in the same dollar amount.

Therefore, the use of this strategy requires strict adherence to risk management. It is necessary to determine in advance the levels upon reaching which the position will be closed with a loss in the event of unfavourable developments. One limitation of a pair trading strategy is that a trader is not assured of the extent to which the correlational divergence between two stocks is temporary. It could last longer than anticipated as a result of fundamental changes in a company. This risk can be managed by setting a stop loss which will automatically exit the trade once the stocks separate beyond a certain point.