Pair Trading, or statistical arbitrage, represents a sophisticated investment strategy that seeks to capitalise on market inefficiencies. By simultaneously taking a long position in one equity and a short position in another, this method strives for market neutrality, minimising exposure to broad market movements.
Rooted in the principle that certain stocks move together due to economic or sector-based correlations, pair trading exploits deviations from their historical price relationships.
This approach is grounded in statistical analysis and offers a hedge against market volatility, making it a favoured strategy among traders who aim for consistent returns regardless of market direction. As financial markets evolve, the relevance and application of pair trading continue to expand, adapting to new data-driven insights and technological advancements in trading.
In this post, we will explore some of the commonly used strategies regarding pair trading.
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Distance Method
The Distance Method for pair trading involves two key steps:
Pair Selection
- Identifying two equities whose prices have historically moved together.
Trade Execution:
- When the distance (e.g., absolute price difference) between these equities exceeds a certain threshold, it indicates a potential divergence.
