What are the advantages and disadvantages of pair trading ?

Pair trading is a market neutral trading strategy which enables traders to make a profit under different market conditions.Without learning about the recent market trend a trader matches a long position with a short position in a pair of highly correlated shares, commodities, currencies or etfs. Usually, the pairing is done in shares of companies which belongs to the same industry. Demat account and trading account are required to trade using this strategy like in others.

Advantages of pair trading are discussed below:

• No risk from market direction

Direction risk means risk associated with movements in price because of change in market direction. For an example, a short position is exposed to the risk that stock prices may rise.In pair trading, no such risk exists. Because here profit depends on the difference in price changes of two stocks which are in the pair not in the direction in which they move.

• Limited risk and profit in different market conditions

The concept of this strategy revolves around matching a long position with a short position in correlated shares which automatically creates a hedge.Therefore risk is always limited and controlled.Another active feature is that regardless of market condition, traders can earn a profit using it.With other trading strategies, long traders are benefited when the market is rising and short traders are benefited when the market is falling. Traders who trade in pairs earn a profit in any market condition (upward, downward, sideways).

Disadvantages of pair trading are discussed below:

• High commission and fee charges

Traders need to pay two commission and other charges to enter and exit each trade.If a trader takes only a long position then he will pay one commission to enter and one to exit trade, but with this strategy charges get double. To overcome this drawback service of discount brokers can be used. They charge fixed commission with every executed order which is very low as compared to the charges of traditional brokers.

• Less profit in low trade volumes

Traders who trade in low volume are not able to earn high returns using this strategy. As partial fills, bid ask spreads reduce profit.Traders have to trade in large volumes to have low bid ask spreads as with low volume it is very high.

Following are few tips to overcome these disdvantages :

• Choose the stock which is traded in high volumes. This will help in reducing the impact of partial fills and slippage.

• Go for services of brokers who charge less brokerage.Traditional brokers charges are very high and also their charges get increased with a number of lots. Discount brokers offer service at a low brokerage.

With good trading experience, traders can perform well using this strategy. The success of this strategy also depends on the choice of a pair you have made.Quality research and proper interpretation of results help in ensuring that you have selected correlated pairs which will help in earning good profit.Profit or loss in pair trading depends on whether spread between paired positions get narrows or widens.