Turning Point in Pairs Trading – Trading Systems – 11 November 2021

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Parish trading is a market-neutral strategy that involves buying one asset and shortening another. Parish trading or the similar trading principle is often used by the hedge funds and institutional investors. As a valuable investment and the economic data, the pair trade well explains the occasion of the turning point. Therefore, if you have the functional knowledge of the park business, it could help you better use price. At the same time, with pair trading, we can still apply the margin of safety and diffusion that we have learned from the value investment strategy. That’s why it’s the best business strategy to be covered in this book.

Parish trading begins by identifying a pair of assets that are likely to have some long-term balanced relationship. When the spread has diverged enough, the strategy will buy the undervalued asset and sell the undervalued asset. The strategy achieves a hedging or risk neutral state by taking two assets simultaneously in a different direction. A pair trading strategy is applicable to Forex and Stock Exchange. The process of the park business can be summarized in the following four steps.

  1. Identify two assets whose prices have moved together historically over a long period of time.
  2. Calculate the correlation, integration, historical spread between two assets.
  3. When the spread between two assets diverges excessively high, then buy the undervalued asset and sell the overvalued asset.
  4. When the spread returns to normal range, close the positions of the two assets to take the profit.

Figure 2-3: Normalized AUDUSD against EURUSD on the top and spread chart below (Diagram: www.algotrading-investment.com, Optimal Diagram)

In addition to the spread being measured between two assets, the trading principle of the pair trade is similar to the value investment. For example, the park business involves recognizing the unusually high spread between the two highly correlated assets while the value investment involves recognizing the unusually high spread between the internal value and the stock price. Therefore, the unusually high spread provides the margin of safety in the trading of pairs. In other words, if the spread is higher, then it favors our positions more but with less risk. Typically, the trader applies the statistical knowledge by selecting the diffusion limit to trigger the entry. For example, as in the standard deviation, the spread 3 could be the bottom line to consider the input. However, the choice of the spread limit for starting a business could vary for different assets. Sometimes the historical spread of some assets shows that spread 4 is the appropriate choice for the spread limit. Sometimes, the historical spread of some assets shows that spread 3 is the appropriate choice for the spread limit. To choose the right spread limit, it is best to inspect the historical spread first in the diagram. However, to provide you with some regular guideline, for the stock market, a spread of 4 or more could be considered to trigger the entry. For the Forex market, the spread 3.5 or higher could be considered as triggering the entry. Because the trading of pairs shares a common ground with statistics, some people refer to the trading of pairs as the statistical arbitrage. As in the safety margin in the value investment, the higher spread between two assets, the absolute spread in fact, can be considered as the higher safety margin.

Because trading pairs involves taking the positions for two assets, this provides some of their own properties that differ from another strategy. For example, we could provide two illustrative examples when the positions are closed with profits. These two illustrative examples are not necessarily the trigger list of scenarios for the movements of two assets. However, we chose them because they can visualize the process of the formation of the turning point better than other scenarios.

For the first example, consider that we bought the one asset with a low price and sold another asset with a high price when the spread diverged quite high. In this example, the asset with a low price (= Symbol B) could make the bullish turning point reach the price level of another asset because they are supposed to move together in the long run. We are in profit due to the sharp rise of the asset with a low price (= Symbol B) after the bullish turning point.

Figure 2-4: Normalized EURUSD against GBPUSD on the top and spread chart below (Diagram: www.algotrading-investment.com, Optimal Diagram)

In the second example, the asset with a high price (= Symbol B) could make the bearish turning point to reach the price level of another asset because they are supposed to move together in the long run. We are in profit due to the sharp fall in the asset with a high price (= Symbol B) after the bearish turning point.

Figure 2-5: Normalized CADJPY versus EURJPY on the top and spread chart below (Diagram: www.algotrading-investment.com, Optimal Diagram)

From the two illustrative examples, we could draw two useful business principles. First, when the spread is high enough, it is possible to have a turning point between two assets. The bullish turning point could happen to the asset with a low price or the bearish turning point could happen to the asset with a high price. As in value investing, the pair trade gives an explanation to the formation of the turning point in the financial market. Second, taking the opposite positions on two assets reduces the risk of market volatility. This is considered the chair or the risk neural strategy. Because we hold one position in the opposite direction to another position, we are less exposed on the market volatility. Although a chair is only an optional practice, you never know whether you like or dislike such a business principle. If you do not understand the hedging effect, you may open a Forex demo or simulation account for educational purpose. Look for two very related assets. Then buy one and sell the other. Monitor the profits and losses of the two assets for some time.

In the Forex market, because you can enter the sell position as well as the buy position, the pair trade may be applicable. The park business may also be applicable to the stock business. If the pair trading strategy provides the high spread between two shares in your portfolio, then you can sell the shares in your portfolio and buy more on the other shares in your portfolio. If the pair trading strategy provides the high spread between one stock in your portfolio and the other stock outside your portfolio, then you can sell the shares in your portfolio and buy the new shares for your portfolio. Because the spread in the park business is calculated in real time, it can be considered as the quantitative trading strategy. This helps us trade with less excitement. In addition, the price pattern can be combined with the pair-trading strategy to improve its performance. In that case, the margin of safety in the pair trade could be applied to confirm the direction of the price pattern. However, there are also some disadvantages for business couples. For example, this technique might be more complicated than another trading strategy. First, they could be more complicated because the technique involves dealing with two assets at once. Second, they could be more complicated because the technique requires some knowledge of statistics and statistical business.

About this Article

This article is the part taken from the rough version of the Book: Science of Support, Resistance, Fibonacci Analysis, Harmonic Scheme, Elliott Wave and X3 Chart Pattern.

https://algotrading-investment.com/portfolio-item/science-of-support-resistance-fibonacci-analysis-harmonic-pattern/

You can also use Pair Trading or Spread Analysis in MetaTrader to perform your technical analysis. Here is the landing page for Pairs Trading Station in MetaTrader 4 and MetaTrader5.

https://algotrading-investment.com/portfolio-item/pair-trading-station/

https://www.mql5.com/en/market/product/3303

https://www.mql5.com/en/market/product/3304

Below is the landing page for Optimal Chart, which is the standalone tool to scan the trading opportunities for all symbols and all time frame in one button click.

https://algotrading-investment.com/2019/07/23/optimum-chart/

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