Trading pairs involve identifying two highly correlated financial instruments, such as stocks, funds, or indices, that temporarily deviate from their historical price relationship. The strategy entails buying the undervalued security (long position) while simultaneously selling the overvalued security (short position), aiming to profit from the anticipated convergence of their prices.
*Key Elements:*
- *Correlation Analysis*: Identifying pairs with strong historical correlations, such as Coca-Cola (KO) and Pepsi (PEP), which tend to move in tandem due to similar market factors.
- *Spread Analysis*: Measuring the price difference (spread) between the two instruments to determine when it deviates from its historical mean, indicating a potential trading opportunity.
- *Mean Reversion*: Assuming the spread will revert to its historical average, allowing traders to profit from the convergence.
*Types of Trading Pairs:*
- *Convergence Trading*: Betting the spread will decrease as prices converge.
- *Divergence Trading*: Betting the spread will increase as prices diverge further.
*Risks and Considerations:*
- *Market Risk*: Changes in market conditions can affect both positions, potentially leading to losses.
- *Model Risk*: Incorrect assumptions about correlations or mean reversion can result in losses.
- *Execution Risk*: Difficulty in executing trades at desired prices, especially for short positions ¹ ².
*Popular Trading Pairs:*
- *Indices*: S&P 500 (SPX500/USD) and Nasdaq (NAS100/USD), which can be traded on platforms like Oanda.
- *Stocks*: Pairs like Coca-Cola (KO) and Pepsi (PEP) or other companies within the same sector ³ ⁴.
