⛓️What is Pairs Trading?
Last updated
Last updated
While pairs trading is common in traditional finance, it is currently highly inconvenient and not widely adopted across the cryptocurrency markets. Until now, there has been no platform that enables users to long one token and short another, with leverage, in a single transaction.
Pair trading is often implemented in one of two ways. The statistical approach looks for two correlated assets that often move together. When the spread between the two assets (i.e., the difference in their prices) deviates from its historical mean, a trading opportunity arises. Traders can buy the underperforming asset while selling the outperforming asset, expecting the spread to mean revert over time.
However, there is also another simpler way to perform pairs-trading, which is more narrative-based. When a trader believes that Asset A will outperform Asset B, then they can go long Asset A and short Asset B, thus netting the difference between the profit on the long leg and the loss on the short leg (if they are correct). Such narrative-based pairs trading is the primary use case of Pear Protocol.
This also works in reverse, if a trader believes Asset B will fall, but doesn’t wish to be outright short in case the market goes up, then they can long Asset A and make a net profit as long as the gain on the short of Asset B is greater than the loss on being long Asset A.
An example of a pair trade would be to be long $ETH and simultaneously short $BTC. This is denoted as $ETH / $BTC.
There are two reasons why you might want to do this. The first is for better risk-adjusted returns (1), and the latter is for narrative trading (2).
As a market-neutral strategy, pairs trading in the crypto market does not rely on the overall market direction to generate returns. Instead, it focuses on the relative performance of the correlated cryptocurrencies. This characteristic allows traders to potentially profit in various market conditions, including bullish, bearish, or sideways markets.
Narrative trading incorporates an understanding of prevailing market narratives or themes that can influence sentiment and price movements of related assets. Identifying dominant narratives in the crypto market enables traders to make informed decisions when selecting cryptocurrency pairs.
For example, if there is a dominant narrative favoring the tokens of a growing Layer 1 Blockchain (e.g. $SOL) versus the price expectation of another Layer 1 (e.g. $ETH), then the trade idea would be to be Long $SOL and short $ETH, possibly with leverage to amplify your gains.