How to Use Pair Trading as a Crypto Investment Strategy
As the cryptoasset market has evolved into a popular asset class for professional traders, there are now more and more advanced trading strategies that are being applied in the crypto markets.
In this guide, readers will be introduced to pair trading and how they can use this market-neutral strategy to generate a trading profit in the cryptocurrency markets.
What Is Pair Trading?
Pair trading is a market-neutral trading strategy that involves buying and selling two highly-correlated financial assets – such as two ETFs, stocks, commodities or cryptocurrencies – to generate a profit when the long position increases in value more than the short position drops in value.
Pair trading is a market-neutral or non-directional trading strategy, which means that trading profits can be generated regardless of whether the market is rallying or correcting.
Pair trading is, therefore, an excellent trading strategy for the highly-volatile cryptoasset markets where the market can easily drop by 50 percent in a matter of months.
Examples of Crypto Pair Trades
For a pair trading strategy to work, it is essential to choose pairs that have a high correlation with one another.
In the cryptoasset markets, one can find different types of digital currencies and tokens with very similar features that act as comparables. For example, traders can find digital currencies, privacy coins, gaming tokens, smart contract platform tokens, and exchange coins, among others. This enables crypto traders to deploy pair trading strategies.
Since not all cryptocurrency exchanges allow investors to short cryptoassets, it may be better to opt for CFD brokers that support cryptocurrencies to deploy this strategy as a retail investor or sign up to crypto futures trading platforms.
EOS vs. ETH
A good example of a pair trade will be to long EOS vs. short Ethereum if one believes that EOS will outperform ETH in the coming weeks or months. To place that trade, a trader has to buy EOS and short the same amount of ETH in U.S. dollar terms.
At the time of writing, this pair has a correlation of 0.81, according to data from CoinMetrics, which means it has a high enough correlation for this trade to make sense. Moreover, both assets are from leading smart contract solutions platforms, which makes them comparable as an asset.
When looking at the chart above, one can see that if a trader would have gone long EOS versus short ETH at the beginning of 2019, their trade would be profitable now. EOS has outperformed ETH during a period where both tokens were highly correlated.
BTC vs BSV
Another great example of a crypto pair trade that would have generated a nice profit would have been to go long BTC and short BSV right after the BCH/BSV fork.
As the chart below shows, since November, the price of bitcoin rallied by around 23 percent while the value of BSV dropped by roughly the same percentage amount. This would have meant a trading profit of around 46 percent (minus short selling and execution fees).
Other interesting trading pairs that could potentially be used for a pair trading strategy would include BTC vs. LTC, ZEC vs. XMR, ETH vs. TRON, NEO vs. NEM, and ETH vs. ETC, among many more.
The key is to find two comparable coins or tokens, analyze their correlation and historical returns, and make a decision on which asset can be determined will outperform the other.
Risks of Crypto Pair Trading
While pair-trading is a market neutral trading strategy is by all means not risk-free. There are several risks and drawbacks investors need to be aware of before deploying this popular investment strategy.
Firstly, there is execution. That means a trader may not be able to execute at the prices they need for the strategy to be optimal. This is especially an issue when trading in small cryptoasset pairs.
Breakdown of Correlation
Secondly, it is important to be aware that correlations change on an ongoing basis. Therefore, if there is a breakdown of correlation, a pair trade could quickly turn sour as assets move in different directions than “they are supposed to.”
Holding Cryptoassets on Exchanges
Thirdly, there is the omnipresent risk of holding cryptoassets on exchanges (if you are is using crypto exchanges instead of CFD brokerages to execute the strategy). Anyone who has been in the cryptomarkets for longer than a few days will have heard the old adage, “never hold your coins on an exchange.”
In light of the very recent Bithumb hack and the dozen of exchange hacks prior, it is evident that exchange wallets are not a safe place to store cryptoassets.
Missing out on the Next big Rally
Finally, there is the risk – or rather the drawback – of potentially missing out on the next big crypto bull market if a trader only uses pair trading as their sole crypto investment approach. As pair trading is market-neutral, this strategy does not financially benefit the investor if the market “moons.”
Should You Start Crypto Pair Trading?
Pair trading is not a strategy for beginners. Unless you are familiar with trading platforms, bid/ask prices, chart analysis, analyzing a cryptocurrency project, and short selling, pair trading is probably not the right approach.
Moreover, if one plans on making bank during the next crypto rally, one should avoid pair trading as it is a market-neutral strategy that will not generate a higher profit during a rally than it would during a market downturn.
However, if a trader is comfortable deploying a more advanced trading strategy and is happy to potentially make a regular profit regardless of the condition of the overall market, then crypto pair trading may be the best strategy.
Of course, as with all (crypto) investing, one should never invest more than they can afford to lose, even if this strategy may seem lower risk than other types of crypto investment approaches.