Pairs Trading in Forex?

A couple of weeks ago, I wrote a short piece about “market neutral” trading strategies.

These trading strategies identify two assets that have a high amount of historical positive price correlation, identify when one is overperforming and the other underperforming by more than a certain amount of standard deviation, and then goes long the underperformer and short the overperformer, in the same cash amounts. Hopefully, the prices of the pairs begin to converge, and when the divergence is reduced to a normal historical level, the trade is exited at a profit. On the other hand, a stop loss is also applied, in case the prices move in the opposite direction.

Although there is a lot of interest in these kinds of “market neutral” strategies, they should not be assumed to be risk free, and another potential drawback for the retail trader is that they often require relatively large capital to operate successfully. That doesn’t mean that such a strategy cannot be applied and so I present a short case study as to how it might be done in Forex. Dominoes

Firstly, you need to identify currency pairs that typically exhibit very high positive price correlations. Examples might be the Australian and New Zealand Dollars, or the Euro and Swiss Franc. There are hardly any currencies that have stronger correlations. The problem is immediately obvious when you look at a long-term chart: although there are lengthy periods of time where the pairs mean-revert, there are points where they uncouple and make strong directional movements. For example, the Australian Dollar depreciated against the New Zealand Dollar by about 25% between 2011 and 2014. The EUR/CHF currency pair tells an even worse story, with the disastrous 2015 uncoupling by the Swiss National Bank wiping out anyone foolish enough to be trading a reversion between these currencies.

Pairs trading is much better done through stocks, either using two indices or two stocks of companies in the same sector. For example, look at the chart showing the comparative performances of the S&P 500 and the Dow Jones 30 Indices – the gap between the lines sometimes widens, but eventually catches up.

S&P 500

 

Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.