Namaste to all #Hive and #Inleo community members. 🙏
First of all, it is important to understand what a trading strategy is.
A trading strategy is basically a systematic method based on predefined rules and conditions used to make trading decisions in securities markets.
While trading the financial markets, you will come across many strategies, most of which you will like and be eager to adopt. But it is not necessary that the strategy which is giving good consistent profits to someone should be equally beneficial for you. But it is very important to understand that no matter how wonderful a strategy is, every trade is a test where you have to keep all your emotions like fear, greed, pride, anger, etc. under control in such a way that you can make more money on the right trades. and lose less on the wrong ones.
In this blog, we will understand a very interesting trading strategy Pair Trading in simple words.
What is Pair Trading
Pair trading is done by creating a long and short position at the same time in two companies that are highly correlated with each other. Meaning, that you buy the stock of one company and sell the stock of another company at the same time. The goal of pair trading is to avoid market volatility and make a safe profit from the difference between the two companies.
How does it work
Think of any two companies that are similar in almost every way. For example - HDFC bank and ICICI bank.
- Both are private-sector banks.
- Both have similar banking products.
- Both cater to the same customer base.
- Both have almost an equal presence in the country.
- Both banks have similar regulatory hurdles.
- Both banks face similar challenges in running the business.
So on and so forth.
Since there are striking similarities between the two banks, whatever change in the business environment will affect one bank, the other bank should also be affected in the same way.
For example, if RBI increases interest rates, both banks will be affected equally and if rates are reduced, the same will be affected.
Given the above inference, we can make the following conclusion –
- Since both banks are similar, their stock price movements should also be similar.
- On any given day, if the share price of HDFC Bank increases, the share price of ICICI Bank is also expected to increase.
- And someday if HDFC share price falls, ICICI share price is also expected to fall.
Despite having almost similar businesses, since these are two different companies with different management. So possibly some day one bank may move slower or faster in its direction than the other.
- It may happen that one bank is announcing its quarterly results - on an immediate basis this will have a greater impact on its stock price than that of the other bank, thereby changing the price relationship between the two, which may then be adjusted.
- Suppose a top executive at one of these banks resigns, causing a sudden drop in its stock price, while the other bank continues to trade regularly.
- One of the most common reasons could be that there is excessive buying and selling in Stock 1 compared to Stock 2 on a given day.
Two examples are given below.
In the image shown above, you can understand the strategy of Pair Trading in HDFC Bank and ICICI Bank which were part of the discussion in our blog.
Similarly, you can understand the correlation and Pair Trading strategy between Hero Moto and Bajaj Auto in the image shown below.
This discrepancy in stock prices is what gives us the opportunity to trade. And this discrepancy can be caused by anything.
In the world of arbitrage, this translates to buying the cheaper stock and selling the expensive one.
TO CONCLUDE, Pair Trading is a strategy that seeks to take advantage of price differences between two assets that are highly correlated with each other. By simultaneously buying and selling the two assets, we try to profit from the “relative value” of the two securities. So you can also refer to Pair trading as 'relative value trading'.
This does not protect you completely from market risks, but with this, you can avoid them to a great extent.
My English is not very good so sometimes I use 'Google Translate'. Please don't think that anything I have written in this blog has been copied from somewhere or is AI-generated.