Pair trading relies on two historically-correlated assets becoming momentarily uncorrelated. This market-neutral trading strategy involves placing a position on an undervalued asset and an overvalued asset at the same time. When effective, traders can turn a profit from positive and negative price movements simultaneously. Crypto pair trading works in the exact same way, except it uses cryptocurrencies instead of stocks or securities. However, the term “crypto pairs” can also refer to a framework that cryptocurrency exchanges use to establish an agreed value for trading.
In this article, we’re going to dive deep into crypto pair trading. We’ll explore how pair trading can help traders to profit from both negative and positive price movements. Also, we’ll discuss the different applications of cryptocurrency trading pairs and how they vary from traditional pair trading.
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Market-Neutral Trading
Before we discuss crypto pair trading, let’s take a look at the underlying concept of market-neutral trading. A market-neutral trader is one who is neither optimistic (bullish) nor pessimistic (bearish) about the price action of an asset or asset class. Instead, market-neutrality enables a trader to seek profits from both negative and positive price movements. Also, a market-neutral trader aims to avoid certain types of market risk. This is usually achieved by investing in two assets at the same time with matching long and short positions.
If the price of one asset goes down and another goes up, a trader can profit from each of them. Effectively, this enables traders to make profits regardless of market conditions. Market-neutral trading strategies intend to avoid substantial losses. Accordingly, one position can counterbalance the other and minimize the effects of poor stock selections. Hedge funds often employ market-neutral trading strategies to generate steady returns in all market conditions. These strategies often have low correlations with markets. They rely on specific convergences in the prices of two assets as a way of hedging against general market risk.
What is Pair Trading?
Introduced in the mid-1980s by Morgan Stanley employees, pair trading is a market-neutral trading strategy that matches a long position with a short position on two highly-correlated stocks or securities. Pair trading involves the use of statistical and technical analysis. Traders can offset each position with the other to create a hedging strategy that can generate profits from a positive and a negative trend.
Furthermore, pair trading relies on the historical notion that the correlation between two stocks or securities is sustainable. When a trader identifies a discrepancy between these correlations, they can match the dollar value of a long position with that of a short position. The long position would typically be placed on a stock or security that is underperforming. Conversely, the short position would be placed on an overperforming stock or security. Thus, a trader can make a profit when the prices of the two assets converge and resume a historical correlation.
For example, let’s take two similar stocks like, Pepsi and Coca-Cola. Historically, these soda stocks have been heavily correlated. Market conditions often affect two similar products or companies in a similar way. So, if there is a strong correlation between Pepsi and Coca-Cola stock, we could use these two assets for pair trading.
Let’s say that Pepsi stock has been outperforming Coca-Cola stock. If the Pepsi stock price increases and the Coca-Cola stock price decreases, we could create a long position on Coca-Cola and a short position on Pepsi. When the price of Pepsi stock goes down, and the price of Coca-Cola stock goes up, a successful pair trading strategy would yield better returns than only making one of those bets.
How Does Pair Trading Work?
Pair trading is a non-directional trading strategy. Rather than identifying individual stocks that are underperforming or overperforming, pair trading tries to establish two stocks with similar characteristics that are trading outside of a historical range. The pair trader buys an underperforming stock and short sells the overperforming stock.
This strategy relies heavily on statistics and technical analysis. It seeks to find minor discrepancies between reliable correlations and make a profit from them before they return to a historical correlation. This is achieved by betting that two assets will diverge or converge in price.
Anyone can participate in pairs trading. However, given the amount of technical and statistical analysis involved, it is usually professional traders who opt for this strategy. Pairs trading requires a robust methodology and a firm understanding of data analysis.
What are the Benefits of Pair Trading?
An effective pair trading strategy enables a trader to maximize profits and mitigate potential risks. Traders can profit from both positive and negative price movements. Pair trading generates profits from two positions simultaneously when the statistical probability of the underlying assets returning to equilibrium is high. Generally speaking, assets that correlate 80% of the time or more are considered for a pair trading position.
Coupling the inflation in the price of one asset with the deflation of another can reduce downside risk when trading. However, pair trading usually requires a lot of capital to turn a profit. Also, there can be limited opportunities for pair trading. It can be challenging to identify sufficient correlations between assets to begin with. Plus, expected outcomes often vary from actual outcomes when relying so heavily on historical data.
Pair trading requires a firm understanding of technical analysis. If you want to take your trading game to the next level, check out the Technical Analysis 101 course at Moralis Academy. This course teaches students how to interpret price movements, create trading strategies, and make decisions based on probabilities rather than emotions. Improve your trades today with Moralis Academy!
What is Crypto Pair Trading?
Pair trading in the traditional sense is absolutely applicable in crypto trading. Furthermore, the crypto markets can present more opportunities to find heavily correlated assets and use them to create a market-neutral trade. That said, the crypto markets are significantly more volatile than traditional markets. As such, reliable correlations are sometimes harder to come by in the crypto space.
However, when we talk about crypto pairs or trading pairs, we generally refer to something different. The term “cryptocurrency trading pairs” usually refers to the way that a buy and sell order is matched on a crypto exchange. Both centralized and decentralized exchanges use trading pairs. If an exchange lists a trading pair, it means that you can swap those two assets for one another and observe the relative value of the two assets irrespective of their fiat values.
How Does Crypto Pair Trading Work?
Crypto pair trading is a market-neutral trading strategy that enables traders to profit from a long and short position that capture value from correlation discrepancies between two assets. This is much the same as pair trading with stocks. However, trading pairs help traders to understand the value of crypto assets without relying on fiat currencies as a point of reference. Although fiat-pegged stablecoins are common in cryptocurrency pairs, pairs help us to figure out how much Ethereum (ETH) there is in one Bitcoin (BTC), or how many Chainlink (LINK) tokens equal one ETH. Altcoins are often paired with BTC, ETH, or a stablecoin like Tether (USDT). These assets act as a base currency to indicate an agreed value between assets.
The base currency is the first currency in the equation. For example, let’s say that Bob has 1 BTC and wants to swap it for ETH. At the time of writing, 1 BTC is equal to 13.51 ETH. So, Bob has to find a BTC/ETH trading pair on his favorite crypto exchange. Here, BTC is the base currency, because it is the first in the equation.
Before entering into a trade on a crypto exchange, it’s worth paying attention to the available trading pairs. You won’t always be able to swap assets in a single trade, particularly when trading lesser-known cryptocurrencies. This means that you may have to make several trades if there is no trading pair available to facilitate a direct swap.
Liquidity Pools
Decentralized exchanges (DEXs) also use crypto pairs. A DEX using an automated market maker (AMM) model relies on liquidity providers (LPs) to provide a trading pair to facilitate decentralized token swaps. LPs provide an equal value of two crypto assets to a liquidity pool on a DEX. In return, they earn transaction fee rewards each time a trader uses an asset from their pair as part of a permissionless swap.
This can be a great way to earn a passive income with crypto. However, providing liquidity to a decentralized finance (DeFi) protocol comes with the risk of impermanent loss. Impermanent loss occurs when the prices of the assets you deposit in a liquidity pool change compared to when you first deposited them. Also, liquidity provision comes with technical risks as DeFi liquidity pools rely on smart contracts. Smart contract hacks and exploits frequently occur in DeFi. Plus, user error is commonplace due to the technical nature of interacting with public blockchain protocols.
Top Trading Pairs
According to CoinMarketCap, Tether (USDT) is the most popular half of any cryptocurrency pair, accounting for 71.60% of all trading pair volume. Bitcoin (BTC) is the second-highest and is present in 42.95% of crypto trading pairs. Furthermore, Ethereum (ETH) is the third most common asset and is present in 19.41% of pairs. Binance USD (BUSD) is the fourth at 4.75%, while USDC is fifth with 4.23%.
You can find out what trading pairs are available using a crypto price data website like CoinMarketCap or CoinGecko. You can search for a specific crypto asset or scroll down the list to search for them in order of market capitalization. When you select a crypto asset, click on the “Markets” tab. After this, scroll down, and you should find a list of crypto trading pairs. Pairs are usually listed with the highest trading volumes at the top.
However, some sponsored listings will place other exchanges at the top of this list. Also, crypto assets receive a confidence score for each pair listing. If an exchange has low liquidity or suspicious activity, it should be visible on these websites next to the relevant token listings.
Crypto Pair Trading Explained – Summary
Crypto pair trading mirrors the phenomenon of classic market-neutral trading. When two crypto assets with a historically-strong correlation decouple, a pair trader can place bets on both of these assets. When the price of the underperforming asset increases and the price of the overperforming asset falls, pair traders can increase their profits and mitigate possible risks.
On the other hand, crypto trading pairs are two assets that can be bought and sold for the other on a crypto exchange. When providing liquidity to a decentralized exchange (DEX), liquidity providers put up an equal dollar value of two crypto assets. Accordingly, anyone who interacts with a liquidity pool can interchange either of the two crypto assets that make up the crypto trading pair.
If you want to learn how to make the most out of decentralized finance (DeFi) protocols, check out the Master DeFi in 2022 course at Moralis Academy. This course teaches students how to interact with some of the most prominent DeFi platforms using the MetaMask Web3 wallet. Also, students learn about staking, yield farming, liquidity pools, DeFi security, layer-2 solutions, and much more! Kickstart your DeFi journey today with Moralis Academy!
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