There are two distinguishing elements that separate success from failure in cryptocurrency trading: knowledge and experience. These are both essential.
Since trading is a journey that can take years to perfect, the edge lies in whether or not you make a profit. Regardless of the strategy adopted or how astute a trader’s initial evaluation was, profits, especially in day trading, matter. Success creates an impetus that instills confidence.
Solid knowledge of different asset pairs is imperative and helps traders make informed decisions. When building expertise, traders learn how assets correlate and react. In turn, the accrued knowledge further refines their inter-market analysis. The inter-market analysis entails studying price correlations between different markets.
What is Pair Trading?
Correlation is a very important aspect of pair trading. However, it must be understood that the cryptocurrency market is maturing and related assets are emerging. The coins are also designed to be decentralized, meaning that there are fewer correlating assets that drive the prices of individual coins or tokens.
In pair trading, traders can “pair” a long and a short position of two highly correlated digital assets under an assumption based on historical prices that the two assets are connected and their prices fluctuate around a mean. When prices revert, shrewd traders place their positions.
The objective here is to make profits through the exploitation of price differentials and the eventual correction when the prices snap back to equilibrium. To “pair,” traders, upon discovering an anomaly, go short on (sell) the overperforming asset and go long on (buy) the underperforming asset.
Note that there are different factors that can cause prices to diverge, forcing spreads to widen:
- Disagreements within the developer community, forcing a hard fork
- Hacks because of security flaws within a cryptocurrency exchange
- Rumors and stories around new regulations
Pair trading was first introduced by Morgan Stanley arbitrage market researchers in the 1980s. It is a subset of statistical arbitrage and is deeply rooted in math and statistics. Anchoring its success was the use of technical and statistical analysis to identify market neutral pairs due to market inefficiencies thanks to a mathematical concept known as cointegration. Cointegration is the distance in the price of two correlated assets over time.
Different from cointegration, correlation is the tendency of assets to move in a specific direction in relation to each other. It is a term derived from regression analysis, which studies the relationship between independent and dependent assets. Correlation values range from -1 to 1. The more negative the value, the lower the correlation.
A market-neutral position is an asset position that seeks to make money irrespective of the overall performance of the market.
There are three methods for testing cointegration:
- The Engle-Granger two-step method
- The Johansen test, suitable for large samples
- The Phillips-Ouliaris cointegration test
In a nutshell, pair trading is a market-neutral trading strategy that traders can exploit for risk-mitigation purposes.
As no market is entirely risk-free, pair trading can be incorporated in a trading strategy and subsequently used to shield a particular trading strategy.
Features of Pair Trading
The strategy works by identifying price differentials between two assets or markets where the focus is not on individual crypto assets. Instead, the focus is on their historical relationships.
When they notice a correlation discrepancy, traders can “pair” highly correlated assets by taking a long position on one asset and simultaneously taking a short position on the other, correlated asset. The higher the correlation is, the better, as correlation is the primary driver of this strategy.
As a risk-mitigation strategy, these two offsetting positions are the basis of hedging, since the objective is not to make money but to protect the trading strategy. If the trade goes as expected and the undervalued asset’s value inflates more than the counter position, then the investor will not only profit but also have planned for potential losses.
This might look easy on paper, but implementing this strategy can be a tad complicated. Difficulties arise when identifying trading pairs. Once traders overcome this obstacle, then they ought to identify the entry and exit points and build a profitable strategy that generally works. Remember, the market can remain irrational more than a trader can remain solvent.
The second step is to calculate the spread, or the price ratio, and plot it on the chart. The spread is the price deviation from the mean, and this involves checking the historical divergences. The price ratio is the ratio between the two assets’ spot rates.
These two can factor into other indicators, such as Bollinger Bands. The Bollinger Bands indicator is effective in identifying overvalued and undervalued assets ripe for pair trading.
Advantages and Disadvantages of Pair Trading
There are different strategies for identifying pairs. However, an important ground rule that you should consider before jumping in is that the chosen assets must have a strong positive correlation and that you have considered any possible factors that could affect cointegration.
Here are the pros and cons of pair trading:
Picking Cryptocurrency Trading Pairs
Usually, to avoid substantial losses, traders need to do some legwork: in-depth research when scouting for suitable trade pairs.
As mentioned earlier, the second step is to map out the proper entry and exit points. This, regardless of the state of the market and even whether the method is non-directional, involves both fundamental and technical analysis. Timing is everything, and proper entry can spell the difference between profit and loss.
The next step is to gather up the courage to execute the trade. Since this is usually a counter-move, traders should put in place proper risk management measures. Otherwise, without trailing stop or stop-loss orders, trend resumptions could trigger a margin call.
How to pair trade in cryptocurrency:
Pair trading works in virtually all markets as long as there is a high positive correlation. The cryptocurrency market is no different. Although the industry is all about independence and decentralization, centralized exchanges dominate crypto trading. As such, data can be readily pulled and analyzed for correlation and cointegration analysis.
CoinMetrics is a platform that assists traders in picking out pair trading assets. These assets can be from different digital asset classes. For example, there are cryptocurrencies like Bitcoin and Litecoin; privacy coins like ZCash and Moneron; smart-contracting coins like Ethereum (ETH), EOS, and Tron; gambling tokens like Loans, Supply, and Logistics; and so forth.
Thanks to CoinMetrics, traders can get a better understanding of cryptocurrency trading pairs. Here is how different assets correlate.
ADA and ETH have the highest correlation: 0.79. They are perfect candidates for pair trading.
Traders can go long on ADA and simultaneously go short on ETH with the belief that ADA will outperform ETH in the immediate term, depending on the trader’s preferred time frame. Accordingly, the traders calculate the spread and the z-score and then use technical indicators like Bollinger Bands to buy, say, $100 worth of ADA and sell $100 worth of ETH at the right time and for risk management. Indicators can guide traders in risk management.
Alternatively, traders can deploy trading bots from, for example, the Xena Pro desktop terminal. Besides backtesting, the terminal is easy to use for all classes of traders. Algorithmic trading has advantages over manual trading. In a high-frequency trading environment where speed matters, traders can deploy dispassionate robots that automatically calculate the spreads and z-scores before placing pair positions emotionlessly while factoring in commissions and other related costs.
Best Cryptocurrency Pairs to Trade
While it is up to traders to choose a base currency for pair trading, liquidity matters. These are the top base currencies that traders should use:
- Bitcoin (BTC) is the most versatile cryptocurrency and is supported by most exchanges. The only hindrance is confirmation times and transaction fees, which can be high in a trending market.
- Ethereum (ETH), being the second-most liquid currency, is also versatile and useful when pair trading with Ethereum-based tokens.
- Litecoin (LTC) is another option. The coin is moderately liquid and has a spot in the top 10. Unlike BTC, the wait time is low, and the associated network fees are low.
- Tether (USDT), a stablecoin, has the support of most exchanges. In less than five years after its launch, the coin has become instrumental and a safe haven in bear markets. USDT is pegged 1:1 to USD.
These are the risks associated with cryptocurrency pair trading:
To reiterate, no market is risk-free. Risk must be factored into any trading plan. In pair trading, these are risks that traders must note:
- Execution and liquidity risk: Entry is key. However, some crypto assets are more liquid than others. There can be costly slippages along the way, cutting into profits.
- Risk of correlation breakdown: The correlation between different assets can suddenly break because of fundamental or technical factors. The resulting divergence can be too much to bear, even more so if there is no risk management strategy in place.
- Risk of FOMO: Pair trading is a hedging strategy. While traders place a counter position for scalping, market forces could suddenly swing and rally. Not only will this force traders to cut their losses, but the entry will be higher than it would be otherwise, translating to lower profits.
- Hacking risks: When an exchange is hacked and trading activity is suspended, that doesn’t mean trading stops. The cryptocurrency market goes on regardless of traders’ predicament. It is therefore advisable to only trade on a reputable platform like Xena Exchange. Security, innovation (such as introducing dAccs), and transparency are identifiers of a client-centric exchange that can be trusted with assets.
Pair Trading on Xena Exchange
Xena Exchange supports pair trading. Advanced and user-centric, Xena exchange offers proprietary indicators, zero credit risk and cheap margin trading of Bitcoin, Ethereum, and XBTVAR contracts.