| What is pair trading? If you haven't done pair trading | | | | Now when you pair trade stocks, you are striping out |
| before, pair trading is done with two almost similar | | | | the market influence from your position by going |
| stocks. Pair trading is highly popular with professional | | | | short on one and long on the other. These two |
| stock traders when they take simultaneously a long | | | | positions cancel each other as the market moves |
| position in one stock and a short position in another | | | | since both similar stocks are supposed to move in |
| almost similar stock in equal dollar amounts. Both | | | | the same direction. |
| these stocks are almost similar but are experiencing a | | | | Currencies can also be viewed as stocks with |
| dislocation. This dislocation in these two stocks is | | | | countries replacing companies. Just like companies are |
| used for hedging purposes. | | | | affected by the broader economic fundamentals in |
| What you do is try to find two stocks in the same | | | | the same way countries get affected by sovereign |
| industry and the same sector with a strong historical | | | | debt, trade protectionism, trade balance, budge |
| correlation between them. Yet for the time being, | | | | deficit and so on. These things affect the respective |
| these two stocks are experiencing dislocation with | | | | currencies. Now two countries in the same region |
| one stock higher in price as compared to the other | | | | with strong trade and economic relationship can have |
| stock. Overtime, both the stocks are going to | | | | their currencies behave in almost similar fashion. This |
| converge to the same price level. | | | | is the basis of pair trading in forex. |
| You benefit from this convergence by going short on | | | | Japanese Yen (JPY) was a popular carry trading |
| the higher priced stock and going long on the lower | | | | currency. Traders were happy selling JPY and buying |
| priced stocks. So when both the stocks converge, | | | | another high yielding currency like AUD. But in 2009, |
| you make profit. If both don't converge, you don't | | | | carry traders lost their risk appetite and suddenly |
| lose much. So in pair trading, you try to profit from | | | | started unwinding their yen positions. This massive |
| the convergence of the two stock prices to the | | | | buying back of JPY made JPY appreciate. So this |
| historical levels. | | | | appreciation of JPY is short term. |
| Now this same strategy can be used in currency | | | | Korean economy is closely tied to the Japanese |
| trading. The good thing in currency trading is that you | | | | economy with its Won doing well but you can profit |
| don't have to buy two separate currencies. Pair | | | | from this short term divergence in JPY and Won by |
| trading is sort of in build in it as you can only trade | | | | trading the pair JPYKRW. Similarly you can pair trade |
| currency pairs meaning you can go short on one and | | | | Euro and Pound! |
| long on another or the other way around. | | | | |