Pairs trading or “statistical arbitrage” is a stock trading strategy through which the investor simultaneously buys and sells two (normally) correlated stocks when they diverge from their typical pattern with the expectation of capturing a profit when the pattern returns to normal. Pairs trading is a market neutral position that enables the investor to profit from both uptrends and downtrends in market prices. Pairs trading was developed in the 1980s with the introduction of online investing.
How Pairs Trading Works
A pairs trading strategy can be implemented with stocks, options, currencies, and with futures. To implement a pairs trade, the investor would first identify two instruments (e.g. stocks) which have historically demonstrated a strong correlation. Often, these stocks are in the same or in related industries. When a diversion from the norm presents itself, the investor takes a long position in the stock that is over-performing and a short position in the stock that is under-performing. A profit is realized when the stocks return to their usual correlation.
Choosing Stocks for Pairs Trading
In choosing stocks for pairs trades, the investor will look for stocks that have proven to move in a similar way, operate similar business models, and are likely to be affected similarly by economic and market events. Often, investors will look for low-volatility stocks that operate within the same sector and have similar market caps.
The Risk of Pairs Trading
While investors can and do earn significant profits from a pairs trading strategy, there is risk involved. This risk can be managed through the use of stops when executing pairs trades.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.