What is Pairs Trading? How can we use it?

Pairs trading is a non-directional, relative-value investment strategy that seeks to identify 2 investments or funds with similar characteristics whose equity securities are currently trading at a price relationship that is out of their historical trading range.

This investment strategy will entail buying the undervalued security while short-selling the overvalued security, all while maintaining market neutrality. It can also be referred to as market neutral or statistical arbitrage.

This trading strategy uses statistics to identify relationships, assist in determining the direction of the relationship, and then ascertain how to execute a trade based on the data. The pairs trader attempts to capitalize on market imbalances between 2 or more financial instruments, such as stocks or funds, in anticipation of making money when the inequality is corrected.

To measure these relationships, the pairs trader will use statistics, fundamentals, technical analysis, and probabilities. One of the main keys to pairs trading is finding strong correlations between financial instruments, thus building a foundation for further analysis. The empirical data are then analyzed to find information that allows the trader an efficient and methodical way of executing successful trades.

Pairs trading is by no means a holy grail of trading and will have its ups and downs, like any other trading style.

Pairs work is based on a correlation between 2 (or more) stocks, sectors, indexes, or other financial instruments. Think of a highway and the service road that often runs parallel to it. Generally, the service road follows the highway closely but terrain or development will sometimes cause the 2 to diverge. The area between the highway and the service road can be thought of as the spread—the measured distance between the 2 objects traveling together. The pairs trader attempts to measure the spread with statistics in an effort to find a tradable relationship of inequality opportunities.

In a nutshell, pairs trading works by betting that 2 or more securities will diverge or converge in price. The trader bets that a $50 stock and a $55 stock, for instance, will either have a larger or smaller spread ($5 in this case) when the trade is closed. Divergence traders will like to see the spread increase while convergence traders will prefer to see the spread decrease.

Anyone can use pairs trading but it has tended to be employed by professionals and those with a good understanding of short selling. Transforming pairs trading from a theoretical construct into a practical reality capable of generating profits will involve several steps:

1. Formulate the selection criteria
2. Generate a list of candidate trades
3. Perform technical, fundamental, or other statistical overlays
4. Execute the trade
5. Manage the trade
6. Close the trade

The successful execution of each of the steps is a critical element in the process of becoming a profitable pairs trader.