Make sure, if you are planning to determine if two different assets are correlated, that you compare the returns, as opposed to the price. A correlation of one, means that two assets move perfectly in tandem. A correlation of negative one means that the returns of the two assets move in the opposite direction and are inversely correlated. While correlation describes the returns of two different assets, the statistical measure co-integration describes how well each assets returns are linked, and the strength of their correlation.

An example that is often used to describe co-integration is an old man that is walking his dog that is on a lease. The two can move independently, but because they are linked by a leash, there random paths will eventually converge. An example using securities is as follows. Gold and oil prices might move in tandem for a period of time, but there is no link between the two commodities, so over time, the correlations will break down.

Gasoline and oil, on the other hand, are co-integrated, as gasoline is derived from oil. Over time, the two assets will move in tandem and even if the link occasionally breaks down, it will eventual bounce back. Co-integration is represented in a manner that is similar to correlation. A co-integration of 1, means that the pair is perfectly co-integrated, while a co-integration of -1 means that there is absolutely no co-integration. You can measure the co-integration of a cross currency pair by breaking it down into currency pair versus the US dollar.

An example of two stocks that are co-integrated are Visa and MasterCard. Both of these companies operate similar businesses and generally have highly correlated returns. The ratio of these companies stock prices historically trade in a range , but when the ratio moves a specific standard deviation from a mean of the ratio, you can take advantage of the divergence. One of the best ways to evaluate asset pairs is to look at them on a chart. Currency pairs are the easiest pairs to analyze because the exchange rate used is always reflected as a ratio.

Nearly all charting software platforms provide currency cross pairs which exclude the US Dollar. If you do not have a software product that charts cross pairs, you can chart them on your own, by calculating the exchange rate.

Assets pairs other than currencies generally require some form of software flexibility. You will either need to calculate the ratio on your own or, have a charting software that provides you with this flexibility. When you calculate your pair, you should always use a ratio as opposed to the differential.

There are two basic types of pair trade strategies; mean reversion and trend following. When employing a forex correlation pair strategy you either believe that a pair that has been moving in tandem will experience a breakdown in its correlation, or you believe that after the correlation has broken down, the pair will revert back to its long term mean.

When a pair is co-integrated, it usually means that it will likely move in tandem and if the correlation breaks down, you should expect that it will revert back to its long term mean. If an asset pair is not co-integrated, then you are not sure if it will mean revert, which makes the pair a possible candidate for a trend following strategy.

When evaluating assets for a mean reversion pair strategy, a pair trade becomes attractive when one asset is considered relatively inexpensive or dear relatively to another asset. Since the risk you are assuming is a relative value risk, you are taking on exposure that is uncorrelated to market direction.

This type of trading strategy allows investors to diversify their portfolios by allocating capital to a strategy other than directional changes in stocks or bonds. One of the most common types of pair strategies is one that is based on mean reversion. Here you would seek to benefit when highly correlated assets experience a divergence in returns over the short term. You can also trade pairs based on momentum or a trend, similar to the way you would trade an individual asset such as gold.

You can also use technical, statistical or fundamental analysis to generate a trading strategy. Your strategy can be based on a back test of the relationship between two specific assets that are related to determine if a specific standard deviation from a historical mean of their ratio represents attractive levels to purchase one asset and simultaneously sell short another asset.

The above chart plots the price of gold divided by silver. In a typical calendar spread, trader would buy a longer-term contract and go short a nearer-term option with the same strike price.

If two different strike prices are used for each month, it is known as a diagonal spread. The typical calendar spread trade involves the sale of an option either a call or put with a near-term expiration date and the simultaneous purchase of an option call or put with a longer-term expiration.

Both options are of the same type and typically use the same strike price. And there is a reverse calendar spread - where a trader takes the opposite position; buying a short-term option and selling a longer-term option on the same underlying security.

To sum up in technical terms, the calendar spread provides the opportunity to trade horizontal volatility skew - different levels of volatility at two points in time - and take advantage of the accelerating rate of time decay, while also limiting exposure to the sensitivity of an option's price to the underlying asset. The horizontal skew is the difference of implied volatility levels between various expiration dates.

Hypothetically, AmerisourceBergen Corp. This calendar spread will pay off the most if ABC shares remain relatively flat until the Jun options expire, allowing the trader to collect the premium for the option that was sold. Then, if the stock moves upward between then and July expiry, the second leg will profit. The ideal market move for profit would be for the price to become more volatile in the near term, but to generally rise, closing just below 85 as of the Jun expiration. This allows the Jun option contract to expire worthless and still allow the trader to profit from upward moves up until the July expiration.

The market is full of ups and downs that can kick unprepared weak players. Fortunately, using market-neutral strategies like the pairs trade, investors and traders can find profits in all market conditions. The appealing part of Pairs trade strategy is in its simplicity.

Education Forex Trading Strategies Trading Styles Strategies Pair Trading Strategy. Confirm the theory on practice. Once opened Demo you will be supplied with educational materials and online support.

Open Demo Account. IFCM Trading Academy is for all levels of Forex, CFD and Crypto Trading Education. Start Learning. Bitcoin is New Gold! Now you can trade CFDs on Crypto with IFC Markets. A pair trading strategy works based on the assumption that, if two financial instruments have had positive correlation in the past, they will continue to do so in the future. Pair trading is best employed when a divergence in the price of two positively correlated instruments is identified, with the assumption being that the historic correlation will lead to the prices moving back towards each other after the divergence.

This is most effectively explained with an example. Let's say that we establish a very high positive correlation between the stocks of Company A and Company B.

Despite the historically high correlation, Company A's share price begins to increase , whilst Company B's share price decreases. The logic behind a pair trading strategy is that, eventually, the price of the two stocks will move back towards each other due to their high correlation. In this scenario, therefore, a short trade would be placed on the stock of Company A and a long trade on Company B's shares in the hope of profiting on one, or maybe both, of the price movements when the assets move back towards one another.

The first step towards creating a stock pair trading strategy is to identify two financial instruments which have a high positive correlation.

But how can you do that? It is possible to look at two different instruments and come to the conclusion that, due to a commonality, there may be correlation between the two. For example, stocks of companies which operate in the same industry, such as Coca Cola and Pepsi or Dominos and Papa Johns, might be expected to have a positive correlation.

Looking for logic behind correlation is an important step for some people. This is because it is entirely possible that two completely different things have a strong correlation by pure coincidence. This might not matter to some people, but to others this would be a reason to ignore these pairs when creating a pair trading strategy.

For traders who choose Admirals, it is very straightforward to evaluate correlation between different financial instruments with the Admiral Correlation Matrix! The Correlation Matrix is a tool which comes with the FREE MetaTrader Supreme Edition MTSE plug-in for the MetaTrader trading platforms.

Once you have downloaded MTSE from Admirals, in order to open the Correlation Matrix, you will need to head to the 'Navigator' window on the left-hand side of the screen and select the ' Expert Advisors ' drop down.

Once open, you can select the instruments which you wish to compare. In this example, we will be looking at four petroleum companies, over the last days, to illustrate a possible stock pair trading strategy. The Correlation Matrix will display numbers between to between the instruments. If a number is negative, it means the correlation is negative and, if positive, the correlation is positive. A negative correlation means that if one of the instruments goes up, the other one goes down - and vice-versa.

The closer the number is to or , the stronger the correlation. A correlation of 0 would imply that there is absolutely no correlation, positive or negative, between the pair - this is a very rare situation.

In the Correlation Matrix, the strongest correlations are shown in red. The matter of what number constitutes a "strong" correlation depends on the trader in question and the pair trading strategy which they have constructed. However, a popular cut-off figure among many traders is Straight away you will see that there is a high positive correlation between all four of the above stocks.

The highest is between the stocks of BP British Petroleum and RDSA Royal Dutch Shell Plc with a score of Now that the strong positive correlation has been established between the two stocks, a trader must wait for a deviation between the two prices.

Let's imagine that the price of BP decreases, whilst the price of Shell remains the same. Now a change in price has been identified, the next stage of our stock pair trading strategy is to initiate a short sell position on Shell whilst a long buy trade is opened on BP.

We are banking on the prices continuing their historical correlation and have, therefore, covered both bases. If BP's share price rises back towards its previous price, the long trade would profit. If Shell's share price decreases, the short trade part of our stock pair trading strategy would profit. Of course, this is not an exact science. In our stock pair trading strategy example, it is possible the prices will not realign.

The strategy is based on the assumption that historical correlation will continue, but this will not necessarily always be the case. To benefit from the Correlation Matrix and numerous other Expert Advisors and technical indicators, download the MetaTrader Supreme Edition plug-in from Admirals!

Pair trading is a trading strategy that involves matching a long position with a short position in two stocks with high correlation. Strategy is based on the historical correlation of two stocks. The pair trading strategy is best used when a trader detects a correlation divergence. Based on the historical belief that two securities will maintain a certain correlation, should be used when correlation falters. Profits are possible when underperforming stock regains value and the price of a higher quality security falls.

The net profit is the total gained from the two positions. Pairs trading strategy works with stocks as well as with currencies, commodities and even options. Spread Trading is the act of purchasing one security and selling another related security as a unit.

Spread trades are usually used with options or futures contracts, to get an overall net trade with a positive value called the spread. Spread Trading is done in pairs which eliminates execution risk. The calendar spread is an options strategy that consists of buying and selling two options of the same type and strike price, but different expiration cycles. Calendar spread is an option or futures strategy that occurs by simultaneously opening a long and a short position on the same underlying asset, but with different delivery dates.

In a typical calendar spread, trader would buy a longer-term contract and go short a nearer-term option with the same strike price. If two different strike prices are used for each month, it is known as a diagonal spread.

The typical calendar spread trade involves the sale of an option either a call or put with a near-term expiration date and the simultaneous purchase of an option call or put with a longer-term expiration. Both options are of the same type and typically use the same strike price. And there is a reverse calendar spread - where a trader takes the opposite position; buying a short-term option and selling a longer-term option on the same underlying security.

To sum up in technical terms, the calendar spread provides the opportunity to trade horizontal volatility skew - different levels of volatility at two points in time - and take advantage of the accelerating rate of time decay, while also limiting exposure to the sensitivity of an option's price to the underlying asset. The horizontal skew is the difference of implied volatility levels between various expiration dates.

Hypothetically, AmerisourceBergen Corp. This calendar spread will pay off the most if ABC shares remain relatively flat until the Jun options expire, allowing the trader to collect the premium for the option that was sold. Then, if the stock moves upward between then and July expiry, the second leg will profit. The ideal market move for profit would be for the price to become more volatile in the near term, but to generally rise, closing just below 85 as of the Jun expiration.

This allows the Jun option contract to expire worthless and still allow the trader to profit from upward moves up until the July expiration. The market is full of ups and downs that can kick unprepared weak players.

Fortunately, using market-neutral strategies like the pairs trade, investors and traders can find profits in all market conditions. The appealing part of Pairs trade strategy is in its simplicity. Education Forex Trading Strategies Trading Styles Strategies Pair Trading Strategy.

Confirm the theory on practice. Once opened Demo you will be supplied with educational materials and online support. Open Demo Account. IFCM Trading Academy is for all levels of Forex, CFD and Crypto Trading Education. Start Learning. Bitcoin is New Gold! Now you can trade CFDs on Crypto with IFC Markets. Trade Now. Boost your Profits with IFCM Invest Let Professionals Earn for you! Invest Now. View All Forex Trading Strategies on One Page. Related Trading Strategies. Free Demo Trading. Corporate clients, for you here.

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The platform allows you to trade via its website or through third-party providers MT4 and MT5. Open Demo Account. In fact, when opting for eToro, you can try the best forex day trading strategies discussed today in a risk-free manner. You can calculate this yourself by using a spread sheet like excel. A pair trading strategy works based on the assumption that, if two financial instruments have had positive correlation in the past, they will continue to do so in the future.

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