|
Online trading India is on a rise. Many a time, traders come across the term “risk-free trading”. Although in reality it is virtually impossible to trade a purely risk-free strategy, certain strategies can definitely fit the description of having less downside risk than others. Without a doubt, Pairs Trading falls into this category. Pairs trading involve the idea of choosing two correlated financial products (or groups of products), figuring out what their historical correlation is, and making the assumption that this correlation will hold true in the future. Essentially, a trader in online share trading is different from Pairs trading, where in the latter, betting that more likely than not, this correlation should hold true in the future. A skilled trader with proper knowledge of position sizing can effectively apply the concepts of Pairs Trading into his/her day-trading strategies. The Benefits of Pairs Trading Just like online trading India, Pairs Trading can be beneficial because it protects the trader from market wide sources of risk. A Pairs Trading strategy that is market neutral can protect the trader from market wide fluctuations. For example, if two stocks are highly correlated, a trader can sell the outperforming stock and purchase the under-performing stock. If the trader holds on to the belief that their relative correlation will come back to normal, then he/she is hedged against market wide movements; eventually, when the stocks regain their historical proportion/correlation, the trader can square off his/her two positions and earn a profit. Here is a basic example. Here are the daily closing prices of Reliance Industries (NSE: RELIANCE) and Essar Oil (NSE: ESSAROIL) for the past 7 trading days: RELIANCE----ESSAROIL----Ratio 765.35----------63.35-------12.08 771.2-----------64.4---------11.98 765.85----------64.85-------11.81 773.75----------66.05-------11.71 773.65----------68.25-------11.34 786.8------------68.2--------11.54 798.3------------69.8--------11.44 Correlation 87.21% The correlation can be calculated easily in Microsoft Excel by using the CORREL function. Since the two products seem to be highly correlated, a trader can look make the judgment that the ratio between the two products should be between 11 and 13. Assume that the next day, the trader notices Reliance trading at 800, while EssarOil is trading at 73. The trader calculates that the ratio between the two products is less than 11 (800/73 = 10.95). Therefore, it seems that this is a good opportunity to get into a trade. In this example, the trader would sell EssarOil and buy Reliance since Reliance is relatively under-performing and EssarOil is relatively over-performing. Since the ratio is approximately 11, the trader would sell 11 shares of EssarOil for every share of Reliance that he purchases. At this point, the trader’s true test arises: when should he/she exit the trade? Patience can be the most difficult aspect of trading! Eventually, the trader is looking to exit the trade once the ratio stabilizes to above 11 and the trader can earn a profit. It is generally a good idea to set yourself a profit objective (and if possible, a stop loss) when entering a trade. In our example, the trader might set the profit objective to be a ratio between the two products. Since the trader felt that 13 was relatively high ratio between the two products, he/she can set 13 as the ratio the products must hit in order for him to exit the trade. Eventually, the trader notices Reliance is trading at 760 and EssarOil is trading at 58.45. The ratio has breached 13! The trader immediately sells Reliance and purchases EssarOil. If he/she had executed 110 shares of EssarOil and 10 shares of Reliance, his/her net profit (before costs) would have been: EssarOil: (73-58.45) x 110 = Rs. 1600. 50 profit Reliance: (760-800) x 10 = Rs. 400 loss Net: Rs. 1200.50 profit As you can see, unlike online share trading, although the market had dropped between his two series of transactions (both Reliance and EssarOil fell in price), the trader was able to earn a profit by hedging his trades. This is the power of Pairs Trading! About Author: Mitchell Clarke is a trading analyst, empowering individual investors to make better investment decisions. He provides industry's best finance decisions on unlimited trading, zero brokerage services on equity, online trading India and currency derivatives (futures and options). For more information on online share trading, you can also visit www.rksv.in.
Related Articles -
online trading india, online share trading, online trading, trading india, online share, online share trading india, share trading,
| 
