What is pair trading? If you have not done pair trading before, pair trading is done with two almost similar stocks. Pair trading is highly popular with professional stock traders when they take simultaneously a long position in one stock and a short position in another almost similar stock in equal dollar amounts. Both these stocks are almost similar but are experiencing a dislocation. This dislocation in these two stocks is used for hedging purposes.
What you do is try to find two stocks in the same industry and the same sector with a strong historical correlation between them. Yet for the time being, these two stocks are experiencing dislocation with one stock higher in price as compared to the other stock. Overtime, both the stocks are going to converge to the same price level.
You benefit from this convergence by going short on the higher priced stock and going long on the lower priced stocks. So when both the stocks converge, you make profit. If both do not converge, you do not lose much. So in pair trading, you try to profit from the convergence of the two stock prices to the historical levels.
Now this same strategy can be used in currency trading. The good thing in currency trading is that you do not have to buy two separate currencies. Pair trading is sort of in build in it as you can only trade currency pairs meaning you can go short on one and long on another or the other way around.
Now when you pair trade stocks, you are striping out the market influence from your position by going short on one and long on the other. These two positions cancel each other as the market moves since both similar stocks are supposed to move in the same direction.
Currencies can also be viewed as stocks with countries replacing companies. Just like companies are affected by the broader economic fundamentals in the same way countries get affected by sovereign debt, trade protectionism, trade balance, budge deficit and so on. These things affect the respective currencies. Now two countries in the same region with strong trade and economic relationship can have their currencies behave in almost similar fashion. This is the basis of pair trading in forex.
Japanese Yen (JPY) was a popular carry trading currency. Traders were happy selling JPY and buying another high yielding currency like AUD. But in 2009, carry traders lost their risk appetite and suddenly started unwinding their yen positions. This massive buying back of JPY made JPY appreciate. So this appreciation of JPY is short term.
Korean economy is closely tied to the Japanese economy with its Won doing well but you can profit from this short term divergence in JPY and Won by trading the pair JPYKRW. Similarly you can pair trade Euro and Pound!