The cryptocurrency industry has so many various financial instruments that have obscure relations that it is challenging even for professionals to navigate it successfully. How do crypto trading pairs work? This question is what we will briefly discuss in this article.
While understanding the minutia of dealing with related assets is a skill requiring honing, we can explain how to get started and what to focus on. Why do you need pairs trading and how bots can help you achieve success?
What is crypto pairs trading?
Different retail traders refer to different things when they talk about crypto pairs trading:
- Placing orders on any pair of digital assets not involving fiat is the first one.
- The second one is the traditional pairs trading approach to hedging against market fluctuations.
We will talk about the second type. It is one of the oldest ways to hedge a long market position by creating market neutral trading situations with minimal risks to your portfolio. Experienced traders tend to use this approach to protect their strong long positions against the risk of a sudden downturn that can occur even during an overall bullish mood in the market.
Volatility management is a very specific skill that should be mastered by any serious investor who wants to stay ahead of the competition and focus on building a strong portfolio.
What are pair trading strategies?
Investors, who create a long market position and protect it by a short market position on a correlated asset, engage in pairs trading. It is a time-tested approach to portfolio building when an investor is concerned with risk management and wants to achieve balance while aiming at making profit on a long position.
The main condition of this approach is to find two or more strongly correlated assets that may not have any direct connections but still experience similar price action. The relation can be caused by a multitude of factors including:
- Similarities in underlying product/platform.
- Overall perception of assets by the market.
- Coincidental similarities in price action.
- Comparable tokenomics and market presence.
Other factors such as price retracements and general trends in the crypto industry also may have an effect on why these assets appear to be connected. However, the focus of any correlation analysis is not on the “whys” of the similarity. It is mainly concerned with the very existence of any correlation between two digital assets.
These occur quite frequently in markets with such an abundance of financial instruments like the cryptocurrency market. While finding them can be relatively easy, identifying good pairings to build a strong cryptocurrency trading strategy can be challenging.
How to pick the right pairing?
We recommend analyzing assets and identifying their similarities in the same fashion experienced retail traders do it when approaching stocks and bonds:
- You need a big trading volume. The crypto pairs trading strategy relies on instant execution of orders and the ability to liquidate both positions to secure profits or immediately stop any losses. High liquidity can be achieved only by assets that are moved in large quantities and frequently.
- Assets must be correlated. The idea is to identify multiple digital assets that behave in the market and react to various relevant industry events similarly. A common approach is to compare several price charts with the same time frame. It can be easily done on the TradingView platform.
- The correlation must be strong. Look for deviations and how common they are. If price action is comparable only on a short sector of the price chart or deviations appear to be too big, the correlation should be analyzed further to decide whether you should use these particular digital assets.
When assets are analyzed, they can be grouped by their price action behavior. Similarly behaving assets can be distributed across several sets that may include dozens or even hundreds of entries. You can open market positions on all of them according to your pairs strategy. This approach is commonly used in all types of investment systems and is called statistical arbitrage.
How to use pairs trading and statistical arbitrage effectively
One of the best ways to utilize this particular trading system is by using automation which is a commonly used tool in the world of crypto. Bots can quickly place multiple orders on a variety of digital assets allowing you to outperform the market.
Companies like WunderTrading offer their users an opportunity to run hundreds of bots simultaneously to create sophisticated statistical arbitrage systems that are fully automated and do not require any additional inputs after you set them up.
This approach can be extremely helpful during periods of apparent market volatility. In fact, if you pick the right technical analysis strategy, market fluctuations can be favorable. Scalpers and day traders know well that volatility is the best moment to make money. You will have more opportunities to make money with pairs trading during volatile periods compared to moments when prices barely move.
The main takeaway
It is necessary to include automation to ensure that you can use strategies like pairs trading and statistical arbitrage consistently. These systems are excellent for hedging risks and building strong balanced portfolios. Without automation it will be close to impossible to react to the ever-changing nature of the crypto market appropriately and quickly.
We strongly recommend all retail traders learn more about statistical arbitrage and pairs trading before committing to these methods.
