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Jun 7, Stock Market , Trading Strategy. Pair trading is a strategy for hedging risk by opening opposing positions in two related stocks, commodities, or other derivatives. This can be a way to profit no matter what conditions the market is in since profit is determined not by the overall market, but by the relationship between the two positions. While pair trading was originally developed and used by long-term investors, it can also be applied by day traders on shorter timescales.

In a pair trade, traders identify two stocks or other financial instruments that are correlated in price. That means that traders have reason to believe that when one stock goes up, the other will go down. To profit off this pair, traders will open a long position on the stock that they believe will go up and a short position on the stock that they believe will go down.

Ty pically, the long stock will be underperforming at the time the position is opened and the short stock will be overperforming. Pair trading operates on the assumption of market neutrality. Essentially, this assumes that two stocks that historically have moved in the same direction will continue to do so.

So, pair traders look for highly related stocks — such as stocks in the same industry, and often direct competitors — that begin to diverge in their price movements. These divergences can take place over a period of a few minutes intra-day, or over a period of weeks or months in the longer term. Under the assumption of market neutrality, pair traders expect that the underperforming stock will eventually return to neutral performance — which means a price increase.

Meanwhile, the same assumption for the overperforming stock indicates that a price decrease should occur. One of the major advantages to pair trading is that the assumption of market neutrality can be violated slightly and positions can still be profitable. In an ideal scenario, traders will see the underperforming stock — which they are long on — increase in price, while the overperforming stock — which they are short on — decreases in price.

The positions would then be closed out when the historical correlated relationship between the two stocks is resumed. But, traders can still profit even if only one stock moves.

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  • Correlation.

Conversely, even if the underperforming stock continues to underperform, as long as the overperforming stock drops in price the short position can yield a profit. Correlation between t wo stocks is key to pair trading. Stocks are said to be perfectly correlated a correlation coefficient of 1 when they move exactly in sync. They are perfectly inversely correlated a correlation coefficient of -1 when they move exactly in sync, but in opposite directions.

Correlations can provide opportunities to realise a greater profit, or they can be used to hedge your forex positions and exposure to risk. If you can be certain that one currency pair will move alongside or against another, then you can either open another position to maximise your profits, or you could open another position to hedge your current exposure in case volatility increases in the market. However, if your forecasts are wrong when trading currency correlations, or if the markets move in an unexpected way, you could incur a steeper loss, or your hedge could be less effective than anticipated.

Trading Forex using Correlation: Strategies, Tips, and Indicators!

The strength of a currency correlation depends on the time of day, and the current trading volumes in the markets for both currency pairs. For example, pairs which include the US dollar will often be more active during the US market hours of 12pm to 9pm UK time , and pairs with the euro or the pound will be more active between 8am and 4pm UK time — when the European and British markets are open. Learn more about the best times to trade forex. The correlation coefficient is used in pairs trading , and it measures the correlation between different assets — in this case, currency pairs.

It ranges from 1 to -1, with 1 representing a perfect positive correlation and -1 representing a perfect negative correlation. If the coefficient value is 0, it means that there is no correlation between the price movements of different currency pairs. The Pearson correlation coefficient is the most used measure of currency correlations in the forex market, but others include the intraclass correlation and the rank correlation.

Partner Up: How Pairs Trading Works with Market Relat - Ticker Tape

In the context of currency correlations, the Pearson correlation coefficient is a measure of the strength of a linear relationship between two different forex pairs. Many traders will use a spreadsheet computer program to calculate the Pearson correlation coefficient, because the method for doing so manually is very complex.

The most highly correlated currency pairs are usually those with close economic ties. The table below gives examples of the correlations between some of the most traded currencies in the world.

What is correlation in forex trading?

The correlations were calculated over a one-day period on 26 November using the Pearson correlation coefficient:. You can trade on forex pair correlations by identifying which currency pairs have a positive or negative correlation to each other. In the conventional sense, you would open two of the same positions if the correlation was positive, or two opposing positions if the correlation was negative.

But, if the correlation was perfectly positive, separate long positions on different pairs might help to increase your profits — or it could increase your losses if your forecasts are incorrect. Traders will typically take positions on correlated pairs in order to diversify themselves while maintaining the same overall direction — either up or down. This could be to protect themselves from the risk of a single pair moving against them, as they will still have the opportunity to profit on the other pair if that happens.

It should be stated, that perfectly correlated currency pairs are very rare, and there is always a degree of uncertainty when trading the financial markets.

What is currency correlation in forex?

You can also trade on forex pair correlations to hedge your risk on your active currency trades. Alternatively, you could open two opposite positions on two positively correlated pairs, and the gains on one would offset the losses on the other.

Partner Up: How Pairs Trading Works with Market Relationships and Correlations

This could be because the Bank of England is expected to dramatically alter interest rates, or there is economic slowdown expected in the eurozone. Learn more about how to short forex. The reason for this correlation is the close relationship between the US dollar, the euro and the pound — with these three currencies being entwined by the strong economic ties between each of their respective economies.

If the correlation is currently present in the market and if the pairs increased in price, you could potentially increase your profit.

What Is Correlation?

Equally, you could open two short positions on these pairs if you believed that the price of one was about to fall. If the positive correlation was currently strong, you would expect the price of the other to fall alongside it. You can take a position on currency correlations with financial derivatives such as CFDs and spread bets. Because you never take ownership of the underlying currencies when trading with these financial products, they enable you to go long and speculate on prices rising, as well as short and speculate on prices falling.

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