Synthetic Pairs Trading

This is far from a complete rundown of synthetic pairs trading. This a brief overview intended to introduce you to the general concepts.

Introduction

“The intuition behind pairs trading goes back to the fundamental principle of investing: ‘buy undervalued - and sell overvalued.’ However, to determine if the asset is truly over or undervalued, we need to know the intrinsic value, which is at best an approximation and largely what value investing sets out to do. Statistical arbitrage and pairs trading tries to solve this problem using price relativity. If two assets share the same characteristics and risk exposures, then we can assume that their behavior would be similar as well. This has the benefit of not having to estimate the intrinsic value of an asset but rather just if it is under or overvalued relative to a peer(s). We only have to focus on the relationship between the two, and if the spread happens to widen, it could be that one of the securities is overpriced, the other is underpriced, or the mispricing is a combination of both.” - Hudson & Thames

Statistical arbitrage and pairs trading are extremely complex subjects that will not be covered here, though we may explore them later. Here, my focus is on one of the tools used to execute those strategies—the synthetic pair. A synthetic pair is simply a position, either long or short, for a pair that is not made available through the exchange. It can be constructed by the trader, rather, by building long and short legs in multiple similarly denominated instruments.

Net Δ Positioning

Though the standard Δ positioning for a new synthetic pair trader should generally be neutral, the ability to rebalance to a net positive or negative Δ allows for an additional dimension of expression in the trade.

Suppose you believe that the prominent alternative L1 assets are all relatively similar in intrinsic value. You can express this belief with a synthetic pair trade.

Consider the following chart:

If you believe that each asset has a similar underlying value, you can bet on a return to equilibrium by shorting the overvalued asset (LUNA) and longing the undervalued asset (DOT) with equally weighted positions—for example, you could allocate $1,000 to your long position and $1,000 to your short position. Although you’ll have two open trades, this effectively creates a DOT/LUNA pair with Δ neutral positioning.

This DOT/LUNA position will not be directly affected by USD- or BTC-denominated movements of the underlying assets. The only thing that matters is the relationship between the two.

This position will be profitable under any of the following conditions:

· DOT increases in price while LUNA decreases in price

· DOT and LUNA both increase in price, but DOT increases faster

· DOT and LUNA both decrease in price, but LUNA decreases faster

Synthetic pair trades introduce an additional avenue for risk management into your portfolio because they are isolated from shifts in the overall market trend. You can further decrease your portfolio risk by diversifying your synthetic pair. For example, if you build your long and short legs around three assets each rather than one, you reduce your vulnerability to asset-specific black swan events. Note, however, that over-diversification creates stationarity in a portfolio.

As you become more comfortable trading synthetic pairs, you can increase the profitability of your trade by regularly rebalancing your portfolio and using your net Δ positioning to expose yourself to movements of the broader market. Suppose you believe that DOT and LUNA return to a price equilibrium but they also both increase in USD value. You can express this belief through your trade by increasing the weight of your long leg—rather than maintaining a 50/50 ratio between your long and short, you can shift the weight to 60/40. This allows you to profit both from a correct bet on the relationship between the underlying assets and from the overall rise in market prices. Similarly, you can rebalance to a net negative Δ if you believe the market is due for a substantial correction.

The Importance of Expression

In the broadest sense, a trade allows us to express a belief about the market and extract profit if we are correct. Synthetic pairs, like options, allow us to express more complex beliefs than those offered by various exchanges. Suppose you’re trading on a fully KYC-compliant FTX account and you believe that BTC.D (BTC Dominance) is going to rise aggressively. FTX does not have a BTC Dominance product so there is no straightforward way to express that belief through a trade.

Synthetic pairs allow us more creativity in our trade expression. Though FTX does not offer a BTC Dominance product, they do offer a BTC-PERP and an ALT-PERP. By constructing a BTC/ALT synthetic pair, we can take a trade that is not organically offered by the exchange. Moreover, we could use our net Δ positioning to increase our profitability if we choose to bet on the USD-denominated moves of the underlying assets.

There is edge in extracting value from bets that are broadly unavailable to other market participants.

Is This Just Fancy Mean-Reversion?

Yes and no. Sometimes, there is a fundamental reason to believe that related assets will continue to diverge in price. This has been the case for AXS and SLP. AXS is a fixed-supply token that allows holders to capture fees from the Axie Infinity universe, whereas SLP is a token without a fixed supply that is earned freely by players of the game. Because there was a fundamental reason to believe that AXS would increase in price while SLP would decrease in price, a bet on AXS/SLP would have outperformed a long position in AXS/USD.

Benefits

Broadly speaking, synthetic pair exposure grants the following benefits:

• Greater price efficiency

• Additional trading opportunities

• Reduced noise

Additional Resources

Beginner

Advanced