#TradingPairs101

Trading pairs involve identifying two highly correlated assets that temporarily deviate from their historical price relationship. This strategy, also known as pairs trading, aims to profit from the assumption that the spread between the two assets will revert to its mean.

*Key Concepts:*

- *Correlation*: Measures how closely two assets move together, ranging from -1 (perfect negative correlation) to +1 (perfect positive correlation).

- *Cointegration*: Tests whether the spread between two assets is stationary, meaning it reverts to its mean over time.

- *Spread*: The difference in price between the two assets, often calculated using logarithms.

- *Hedge Ratio*: The ratio of one asset to another, used to determine the number of shares to buy or sell.

*How Pairs Trading Works:*

1. *Identify Pairs*: Select two assets with high correlation (usually above 0.8) and test for cointegration.

2. *Calculate Spread*: Determine the spread between the two assets using logarithms and calculate the hedge ratio.

3. *Monitor Spread*: Track the spread and calculate the z-score to identify deviations from the mean.

4. *Trade Signals*:

- *Long*: Buy the underperforming asset and sell the outperforming asset when the z-score crosses the lower threshold.

- *Short*: Sell the outperforming asset and buy the underperforming asset when the z-score crosses the upper threshold.

5. *Risk Management*: Set stop-loss levels and monitor cointegration to limit potential losses.

*Example:*

A classic example of pairs trading is Coca-Cola (KO) and Pepsi (PEP). If Coca-Cola's price increases significantly while Pepsi's price remains stable, a pairs trader would buy Pepsi and sell Coca-Cola, expecting the spread to revert to its historical mean.

*Advantages:*

- *Mitigates Risk*: By hedging one asset against another, pairs trading reduces exposure to market volatility.

- *Profit Opportunities*: Pairs trading can generate profits in various market conditions, including uptrends, downtrends, and sideways movements.