A pairs trade is conducted when we think one asset is relatively overbought/oversold relative to another correlated asset. The key metric we look for when determining whether or not a pairs trade is feasible is correlation.
For a pairs trade to make sense, we look for a correlation between the assets of above 0.6. Below 0.6, there is no reason to think the assets will diverge/converge since their price relationship is weak.
So how often do we see correlations between major pairs trades within of 0.6?Study
- NASDAQ and Russell, Gold and Silver, Euro and Pound, Aussie and Canada, Corn and Soybeans.
- Observed rolling 3-month correlations for the past 10 years.
- Computed the % of time that each pair had a correlation between 0.6 and 0.8 (feasible pairs trading range)
We find that the pairs’ correlations stay within 0.6 to 0.8 less than 50% of the time, meaning that should take advantage of these pairs trades when a divergence in price presents itself since the correlations do not stay in line all the time.