Pairs trading

Pairs Trading: A Beginner's Guide

Pairs trading is a strategy that aims to profit from the *relative* price difference between two similar assets, rather than predicting the direction of the overall market. It's a strategy often used to reduce risk, as you’re betting on how two things will move *in relation to each other*, not whether they’ll go up or down overall. This guide will break down the concept for complete beginners. You can start trading on Register now or Start trading.

What is Pairs Trading?

Imagine you're looking at two companies: Coca-Cola and Pepsi. These are both beverage companies, and historically, their stock prices tend to move together. Sometimes Coca-Cola is more expensive than Pepsi, and sometimes Pepsi is more expensive.

Pairs trading takes advantage of situations where this *relationship* deviates from its norm. If Coca-Cola becomes unusually expensive compared to Pepsi, a pairs trader might *short* Coca-Cola (betting its price will fall) and *long* Pepsi (betting its price will rise). The idea isn’t necessarily that either stock will dramatically change, but that the price difference between them will return to its average.

In the cryptocurrency world, we can apply this to similar coins. For example, Bitcoin (BTC) and Ethereum (ETH) are often correlated. Both are leading cryptocurrencies and tend to move in similar directions, though not always identically.

Key Concepts

**Correlation:** How closely two assets move together. A correlation of +1 means they move perfectly together. -1 means they move in opposite directions. 0 means no relationship. See Correlation for more details.
**Mean Reversion:** The idea that prices tend to revert to their average over time. Pairs trading relies heavily on this concept. Read more about Mean Reversion.
**Short Selling:** Borrowing an asset and selling it, hoping to buy it back later at a lower price. It’s a way to profit from falling prices. Understand the risks of Short Selling.
**Going Long:** Buying an asset, hoping to sell it later at a higher price. This is a standard way to profit from rising prices – learn more about Going Long.
**Spread:** The difference in price between the two assets. Monitoring the Spread is crucial in pairs trading.
**Statistical Arbitrage:** Pairs trading is a form of statistical arbitrage, which uses mathematical models to identify and profit from price discrepancies.

How to Find Trading Pairs

Finding the right pairs is crucial. Here’s what to look for:

**Correlation:** Look for coins with a high positive correlation (generally above 0.7). This means they typically move in the same direction.
**Similar Business/Technology:** Coins solving similar problems or belonging to the same sector (e.g., Layer-1 blockchains) are often correlated.
**Historical Data:** Analyze historical price data to see how often the spread reverts to the mean.

Examples of potential pairs:

Bitcoin (BTC) and Ethereum (ETH)
Litecoin (LTC) and Bitcoin Cash (BCH)
Chainlink (LINK) and Polkadot (DOT)

You can find historical data on sites like TradingView, CoinGecko, or CoinMarketCap. Alternatively, you can use a dedicated Technical Analysis platform.

Practical Steps for Pairs Trading

1. **Identify a Pair:** Let's say we choose BTC/ETH. 2. **Calculate the Spread:** Determine the price ratio. For example, if BTC is $60,000 and ETH is $3,000, the spread is 20 (60000/3000). 3. **Analyze the Historical Spread:** Look at the historical spread data. What is the average spread? What’s the standard deviation? Knowing the normal range of the spread is vital. 4. **Identify a Divergence:** If the spread deviates significantly from its average (e.g., rises to 25), this could be an opportunity. 5. **Enter the Trade:**

   *   Short the overvalued asset (BTC in our example, as the spread is high).
   *   Long the undervalued asset (ETH).

6. **Set Stop-Loss Orders:** Protect your capital by setting stop-loss orders on both trades. See Stop-Loss Orders for more information. 7. **Monitor and Close:** Monitor the spread. When it reverts to its average, close both trades to realize your profit.

Example Trade

Let's say:

BTC price: $60,000
ETH price: $3,000
Spread: 20
Historical Average Spread: 18
Standard Deviation: 2

You believe the spread will revert to the mean. You:

Short 1 BTC at $60,000
Long 20 ETH at $3,000

If the spread reverts to 18 (BTC drops to $54,000 and ETH stays at $3,000, or vice versa), you close both positions, realizing a profit.

Risks of Pairs Trading

**Correlation Breakdown:** The correlation between the assets can break down, leading to losses.
**Whipsaws:** The spread can fluctuate wildly without reverting to the mean.
**High Leverage:** Pairs trading often involves leverage to amplify profits, which also amplifies losses. Understand Leverage before using it.
**Transaction Costs:** Frequent trading can lead to significant transaction fees.
**Black Swan Events:** Unexpected events can disrupt the market and invalidate your assumptions.

Comparing Pairs Trading to Other Strategies

Here's a comparison of pairs trading with other basic strategies:

Strategy	Risk Level	Profit Potential	Complexity
Pairs Trading	Moderate	Moderate	Moderate
Day Trading	High	High	High
Buy and Hold	Low	Moderate to High (long-term)	Low

Advanced Considerations

**Cointegration:** A statistical test to determine if two time series have a long-run equilibrium relationship. This is a more sophisticated way to identify potential pairs.
**Z-Score:** A statistical measure of how far the spread is from its mean, measured in standard deviations. A higher Z-score indicates a larger divergence.
**Automated Trading Bots:** Once you understand the strategy, you can automate it using trading bots. Join BingX offers tools for bot creation.

Further Learning

Disclaimer

This guide is for educational purposes only and should not be considered financial advice. Cryptocurrency trading involves substantial risk of loss. Always do your own research and consult with a qualified financial advisor before making any investment decisions.

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