Pairs Trading on Forex

Tommy Bell

1. Pairs Trading on Forex

One of the key advantages of this trading strategy is the absence of explicit stop losses, which can be beneficial for traders sensitive to emotions related to locking in losses. At the same time, profits can be achieved regardless of market direction while minimizing risk. The key is to use so-called market-neutral strategies, one of which is statistical arbitrage—pairs trading, which is accessible to all traders.

The neutrality of the strategy means that its profitability does not directly depend on the price movement direction of individual symbols. This is achieved by creating hedged positions between two or more symbols, where profits and losses offset each other.

Key characteristics of the strategy:

  • Minimal risk: Utilizes low market dependency.
  • No guaranteed profits: Although risk is minimized, profits cannot be guaranteed.

In pairs trading, the key is to simultaneously open positions on two interdependent symbols, where this dependence is typically measured by correlation. The correlation can be positive (e.g., EUR/USD and GBP/USD) or negative (e.g., EUR/USD and USD/CHF).

Example of spread trading: When the spread between two symbols widens:

  • Buy the lagging symbol.
  • Sell the leading symbol.
  • The goal is to profit when the symbols converge again.

2. Creating a Spread Chart

The practical application starts with constructing a spread between two symbols, which can be done in MetaTrader 5 using custom indicators. The simplest way to calculate the spread is by taking the price difference, such as EUR/USD – GBP/USD.

Spread chart visualization:

  • If the spread is significantly widened, it may signal a return to normal levels.
  • Bollinger Bands can indicate deviations from the average spread value, presenting conditions for entering a position.

3. Calculating Position Size for Spread Symbols

It is crucial to correctly calculate position volumes for spread symbols. Since each symbol has a different pip value, position sizes must be adjusted accordingly.

4. Examples of Seasonal Analysis in Pairs Trading

Seasonal analysis in pairs trading uses long-term patterns of symbol movement. For example, when trading the silver-gold spread (XAG/XAU), historical data can help identify periods where the spread shows recurring movements.

Advantages of seasonal analysis:

  • Predefined entry points.
  • Lower risk due to identifying average statistical deviations.

Correlation in Trading

Forex Pairs

Positive correlation (move in the same direction):

  • EUR/USD and GBP/USD
  • AUD/USD and NZD/USD
  • EUR/JPY and GBP/JPY
  • USD/CAD and AUD/USD

Negative correlation (move in opposite directions):

  • EUR/USD and USD/CHF
  • GBP/USD and USD/JPY
  • AUD/USD and USD/CAD

Commodities

Positive correlation:

  • Gold (XAU/USD) and Silver (XAG/USD)
  • Brent Oil (BRENT) and WTI Oil (WTI)
  • Copper (COPPER) and Aluminum (ALUMINUM)

Negative correlation:

  • Gold (XAU/USD) and USD Index (DXY)
  • Oil (WTI) and USD Index (DXY)

Stock Indices

Positive correlation:

  • S&P 500 (US500) and Nasdaq 100 (US100)
  • DAX (GER30) and CAC 40 (FRA40)
  • FTSE 100 (UK100) and DAX (GER30)

Negative correlation:

  • S&P 500 (US500) and VIX (Volatility Index)

Bonds and Currency Pairs

Positive correlation:

  • 10Y US Treasury Note (TNX) and USD/JPY

Negative correlation:

  • 10Y US Treasury Note (TNX) and EUR/USD

Cryptocurrencies

Positive correlation:

  • Bitcoin (BTC/USD) and Ethereum (ETH/USD)

Negative correlation:

  • Bitcoin (BTC/USD) and USD Index (DXY)

How to Choose Symbols for Pairs Trading

  • Check historical correlation: Use Pearson’s correlation coefficient to analyze relationships between symbols.
  • Seasonal dependence: Some symbols show seasonal influences, which can further support pair selection.
  • Volatility: Both symbols should have similar volatility to maintain a balanced spread.

What is Pearson’s Correlation Coefficient?

Pearson’s correlation coefficient (denoted as r) is a statistical method used to measure the strength and direction of a linear relationship between two variables. In trading, this coefficient shows how two symbols move relative to each other.

How Pearson’s Coefficient Works

Applying Pearson’s Coefficient in Trading

  1. Gather historical data:
    • Download price data for symbols (e.g., EUR/USD and GBP/USD) over the same period.
    • Data can be daily, hourly, or minute-based, depending on your trading style.
  2. Calculate the coefficient:
    • Use tools like Excel, Python, or trading platforms (MetaTrader 5 with custom indicators).
    • In Excel: Use the function CORREL(X, Y).
  3. Interpret results:
    • Choose symbols with r > 0.7 for positive correlation or r < -0.7 for negative correlation.

Disadvantages of Pairs Trading

  • Less frequent trading opportunities.
  • Patterns can be disrupted by unexpected events.

Conclusion

The key to successful pairs trading is the correct selection of correlated symbols and the use of seasonal patterns to predict spread movements. Although the strategy is not risk-free, it can provide stable profits if applied with a disciplined approach and thorough analysis.