What is it and how does it work?

A crypto pair trading strategy allows traders to place market neutral positions to potentially generate returns regardless of market direction.

Cryptocurrency pair trading is a popular trading strategy in the crypto markets that allows traders to potentially generate trading income regardless of whether the market is going up or down. Read on to learn what crypto pair trading is and how it works.

What is Crypto Pair Trading?

Before we delve into crypto pair trading, it is helpful to first know what a trading pair is.

A trading pair is simply a set of two crypto-assets that can be traded for each other on an exchange. For example, one of the most popular cryptocurrency pairs is BTC/USDT, which allows traders to trade their BTC for USDT.

Crypto pair trading is a trading strategy in crypto that involves opening a long and short position simultaneously on two highly correlated crypto pairs.

It is a market neutral strategy that lowers the risk of a transaction by shorting one asset and going another, allowing traders to reduce their risk in the volatile crypto markets.

How Does Cryptocurrency Pair Trading Work?

Instead of identifying individual cryptocurrencies that are over or underperforming, crypto pair trading seeks to identify two highly correlated digital assets that are performing outside of their historical range.

Once you identify a correlated trading pair, for example ETH and BNB, the next step is to calculate a ratio or spread between the prices of the two cryptocurrencies. This is done by simply dividing the price of one crypto by the other on the pair, for example ETH/BNB. This ratio is a representation of the relative value between the two assets.

You need to establish the distribution range to identify the trade’s potential entry and exit points. This is done by looking at the range within which the ratio has varied in the past. When the ratio moves beyond the expected range, it indicates a good opportunity to open a trade. If the ratio indicates that one of the trading pairs is overvalued compared to the other, buy the undervalued cryptocurrency and short sell the overvalued one.

This strategy assumes that the ratio will return to its historical average. Therefore, traders close their positions when the ratio moves back to this average by selling the undervalued cryptocurrency and buying back the overvalued one, thereby making a profit.

Pair trading is a non-directional trading strategy. This means that you can apply the strategy whether the market is moving up or down. What matters is how the two correlated pairs perform against each other.

Crypto-asset pair trading requires close monitoring of market conditions and a robust understanding of the correlation dynamics between the selected cryptocurrency pairs. Most traders use a mixture of technical indicators, statistical analysis and historical performance to find potential trading opportunities.

The Pros and Cons of Crypto Pair Trading

As with any trading strategy, digital asset pair trading has unique advantages and disadvantages.

Advantages

The main reason why hedge funds, financial institutions and other crypto market participants use crypto pair trading strategies is because they are market neutral. Crypto pair trading allows traders to potentially profit regardless of the market’s direction – up, down or sideways.
It is considered a low-risk strategy that appeals to traders with a low risk appetite in the volatile crypto market. This involves opening long and short positions, effectively hedging against market risks. This can help reduce losses if the entire market experiences a downturn.
Pair trading allows traders to diversify their cryptocurrency portfolio by trading two correlated assets simultaneously. This can help reduce overall portfolio risk and exposure.

Disadvantages

Identifying two correlated assets requires a lot of knowledge and research. This involves keeping up with the latest news and trends for both assets, which can take a lot of time. Typically you need a correlation of at least 0.80 for a pair trade to be successful. It can be very challenging to identify.
Although crypto pair trading is considered low risk, there are still risks involved (such as holding assets on exchanges).
Crypto pair trading usually assumes that two trading pairs are correlated. However, the correlation may change over time. If the asset correlation breaks, it can lead to losses.

Closure

Cryptocurrency pair trading is an effective trading strategy that relies on the belief that closely related digital assets will eventually return to a historical average after moving apart. It has the potential to generate profit regardless of market conditions.

However, it is important to carefully assess the correlation between the selected cryptocurrencies to avoid making wrong assumptions that could lead to the failure of the strategy and incur losses. Additionally, you should keep an eye on trading fees and consider the added risk of holding crypto assets on centralized exchanges if you are not trading on decentralized exchanges.