HUT : LONG, SDIG : SHORT - Pairs Trading Strategy

I think as investors we are constantly searching for profitable strategies that can navigate through both bullish and bearish phases. One such strategy that has gained popularity among traders is pairs trading. Pairs trading involves exploiting relative mispricing between two correlated securities, aiming to profit from their convergence or divergence.

I would like to share my understanding about pairs trading and how we apply it to create a script to show the spread (z-score) and how to identify a pair.

Understanding Pairs Trading

Pairs trading is a market-neutral strategy that relies on statistical analysis to identify pairs of assets with a historical correlation. The basic premise is that even highly correlated assets can temporarily deviate from their usual price relationship. The goal of the pairs trader is to identify these deviations and take advantage of them.

The pairs trading strategy typically involves the following steps:

Identifying a Pair: The trader selects two assets that historically exhibit a strong correlation. This could be two stocks in the same industry, two ETFs tracking the same sector, or any other pair of securities that are expected to move in tandem.

I choose 2 crypto stocks which has shown they are trading correlated to the price movement of Bitcoin.

Calculating the Spread: The spread represents the difference in price between the two assets. It is usually measured as a standardized z-score or a percentage difference. The spread can be calculated using various statistical methods, such as simple difference, z-score, or regression analysis.

Setting Entry and Exit Criteria: The trader establishes entry and exit criteria based on the spread. For example, if the spread exceeds a certain threshold (indicating an overvaluation or undervaluation of one asset relative to the other), the trader may enter a position expecting a reversion to the mean. Similarly, when the spread narrows or reverses, the trader may exit the position.

Trade HUT at $1.91 LONG on 08 June 2023, and SHORT SDIG at $4.91 on 08 June 2023.

The reason why my script would choose this pair is because HUT is on uptrend and SDIG is going downtrend.

This would give us a good asset value return as seen in next chart, whereas if we choose the other trading pair, we would be suffering a drop in asset value.

Managing Risk: As with any trading strategy, risk management is crucial. As Pairs traders we should often employ stop-loss orders to limit potential losses if the spread continues to widen. Additionally, position sizing and portfolio diversification are important to minimize overall risk exposure.

Hope this article helps to explain how we determine the pair suitable for trading and how the entry and exit points is found.

Appreciate if you could share your thoughts in the comment section whether you think the analysis we used to identify pairs trading is sufficient.

Disclaimer: The analysis and result presented does not recommend or suggest any investing in the said stock. This is purely for Analysis.