Pair trading is a market neutral style of investing that allows investors to take positions without trying to guess the market’s direction. This type of strategy minimizes risk by speculating on the spread between two assets and allows investors to make money while minimizing risk. Pair trading is a type of basis trading in which the investor benefits when the spread between two assets either contracts or expands. The strategy ignores the overall direction of the market as the spread between two stocks might remain unchanged despite a large move up or down in the price of the stocks.
Pair trading lends itself to mean reversion strategies since the movements between two highly correlated instruments generally tend to follow the same direction, but in many cases not at the same magnitude. The difference in the magnitude of the change sets up an opportunity to short one stock while going long another stock.
The volatility or randomness of the stock market can make directional trading difficult and costly. Markets generally tend to trend only about 20% or the time. That means that 80% of the time, the stock markets are consolidating making trend following and breakout strategies difficult.
Using statistical strategies to analyze the distribution of a pair of assets, gives insight into the historical range of the pair relative to a moving average or historical range. By using this type of benchmark, an investor can take market neutral trades on the value of one stock relative to another.
One strategy that can be used to pair trade is a Bollinger band strategy. Bollinger bands use a specific moving average (the default is the 20-day moving average) and measure a specific standard deviation (the default is usually 2) above and below the moving average. For pairs, a trader would attempt to measure the spread (one asset divided by another) and measure the Bollinger bands around the spread. When the spread reaches the Bollinger band high, the spread can be sold. When the spread prints below the Bollinger band low, the spread can be purchased.
Binary Options traders can purchase a call on one asset and a put on another asset simultaneously to replicate the spread. For example, if a trader planned on taking a spread position that took advantage of the decline in IBM relative to Microsoft, the trader could purchase a weekly binary options call on IBM and simultaneously purchase a weekly binary option put on Microsoft, when the spread between the two stocks reaches the Bollinger band low.
Magnum options offers a plethora of assets that can be used in pair trading and provides expert mentors that will teach traders a number of methodologies that can be used when pair trading using Binary Options.
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