Introduction to Pairs Trading
This basic primer into pairs trading is intended to introduce you to the general concept of 1 style in this trading strategy.
This article will discuss the concept of pairs trading. We will explore the idea behind pairs trading, discuss the advantages & considerations needed, run through a few examples and talk about some basic parameters when choosing pairs.
Disclaimer: Everything you are about to read is for entertainment purposes only and should not be seen as financial advice.
Topics
What is pairs trading?
Advantages / Considerations
Examples
Choosing pairs
What is pairs trading?
A synthetic pair trade or pairs trading is a market-neutral trading strategy that allows traders to profit from virtually any macro market condition: uptrend, downtrend, or sideways movement.
With the ability to make your own market through research instead of being at the mercy of the market man - pairs trading open up new trading opportunities with the ability to extract alpha from bets that are broadly unavailable to other market participants.
Remember that these pairs are synthetic positions that do not exist on exchanges independently. Traders need to long 1 asset and short 1 asset to formulate a trade. For example, an ATOM/DOT pair would require one to long ATOM and short DOT in 2 separate trades.
There are 2 main types of pair trading
Trend/narrative based
Statistical arbitrage - mean reversion plays in range-bound assets
This article will discuss the 1st type of pairs trading: trend/narrative based.
In the relatively inefficient crypto markets, narrative/hype cycles often play a more prominent role in the short-term valuations of projects on a far quicker pendulum than tradfi does.
ADVANTAGES
More trading opportunities.
Avoid macro mathematics & isolate your trade set-ups from broader market direction.
Ability to increase exposure to the market without increasing directional risk. (e.g. you have a short bias and are already net short but want to increase $$ exposure - you can utilise pairs as said paired exposure would be mostly unidirectional).
Forces you to keep your ears to the ground with narratives and market flows.
Ability to adjust market positioning (increase/decrease long/short positioning as market bias changes).
THINGS TO BE MINDFUL ABOUT
Additional fees & additional margin needed (twice the number of trades of a normal position).
Be careful in trading low-liquidity markets (slippage, stop runs, black swans).
Funding rate imbalance - when 1 asset in pair has an imbalanced funding rate.
Harder to determine stop losses due to the greater complexity of the trade (can use FTX Quant Zone if need be - not sure about other exchanges)
Can't blindly chart pair charts with the same logic as regular charts. It is mostly a futile exercise to chart the pair chart of 2 unrelated coins like ATOM/GMT. We need to incorporate individual charts as well for a holistic picture. Similar pairings like ATOM/DOT can still be charted, but one must understand the limitations of said charts.
ETH/BTC
Before we venture into more exotic examples, we shall first pay heed to the grandfather of all pair trades, which only some realise they can / should trade when they do not have a strong read on market direction.
Highlighted in the chart is a weekly range reclaim before the biggest Ethereum event / fundamental catalyst since its inception (Merge), which made for a great trade.
A remarkable confluence of technicals and fundamentals.
Some examples
GMT/AXS
New 'to-earn' Ponzi / Old' to-earn' Ponzi.
Despite BTC's downtrend, this pair went up 12x in a few weeks. Just catching the meat of this move would have been profitable.
The idea was based on a straightforward narrative of a new coin in a segment taking away mindshare from the older coin in said segment.
Rotation, as CT calls it.
SUSHI/1INCH -
Simple DEX / DEX pair to play the tailwinds present on 1 coin, whilst BTC traded in a tight range.
INJ/ALPHA
With BTC trading around 20k the day after the FOMC unwind (dump), I was not confident in predicting a market direction for the forthcoming days/weeks and hence was not confident about taking fresh naked positions.
INJ had the benefit of a bubbling Cosmos ecosystem narrative as the Cosmoverse conference approached, as the largest derivatives DEX on Cosmos (with the bonus of not being listed yet on big exchanges like Binance.)
So pairing an Injective long with a short to make it a pair made sense, aka position into strength
.The image below highlights some additional reasonings I had, nothing fancy, but it highlights how one can incorporate both TA & FA into such pair trades
ATOM/DOT
Interoperable layer 1 head-to-head.
Significant tailwinds developed for Cosmos when dYdX announced their migration with ATOM 2.0 on the horizon, coupled with other catalysts within their respective ecosystems.
ATOM's market cap had room to grow relative to other L1s, and traders could front-run any positive news from ATOM 2.0 with the chart looking like this (such as possible token value accrual).
Failed Example
However, it is also crucial to not get complacent due to the alleged 'delta-neutrality' of pairs trading. Adherence to risk management is still an important parameter, as 1 overconfident trade can destroy portfolios.
There has to be a recognition of the implied volatility/risk associated with the assets you incorporate within a pair trade.
For coins with more significant risks of volatility / black swans - it is wise to use risk management practices such as:
Stops on individual coins
Stops on the pair chart itself (possible on FTX using their quant zone)
This FXS/MKR pair had the narrative of FXS (Frax) taking market share from MKR (Dai). A few more days of holding this FXS long would have been a portfolio burner as the Terra Luna implosion took place. FXS, being an algo-stable, went down in sympathy with LUNA as collateral damage.
Choosing Pairs
Generally, you want to incorporate some of these factors when choosing the assets for your pair trades;
Fundamental narratives/catalysts (could be either a buy/sell narrative). Some examples include upcoming news events, changes in tokenomics, memetic narratives, and conferences).
Often you want to pair assets in similar sectors (dexes, metaverse, layer 1s etc.) and be mindful of market capitalisation divergences. Pairing a 100mm altcoin with a 5bn altcoin makes little sense due to the variance in volatility such coins will demonstrate.
Generally, stick with the more liquid coins.
Don't be afraid to get creative. You can create baskets of strong vs weak coins. You can create sectoral baskets to pair each with (e.g. World Cup narrative coins / PoW coins is 1 such idea for the present). You can pair trade using tradfi assets and even pair multi-asset pairs. But, the more variables you introduce, the higher the complexity of the trade gets.
There are opportunities to catch trends on different coins all the time. Beat the crowd, and make your own market.
Most importantly, have fun - a large part of pairs trading is coming up with different theses.
Enjoy that process and reap the fruit.
Much love,
Ayush