Pairs trading is a market-neutral strategy where a trader takes long and short positions in two highly correlated assets. The goal is to profit from price discrepancies between the two securities rather than overall market movements.
How Pairs Trading Works
- Identify Correlated Assets – Traders find two stocks or assets that historically move together.
- Monitor Price Divergence – When the price relationship deviates from historical norms, a trade is initiated.
- Enter the Trade – The trader buys the underperforming asset and sells the outperforming asset.
- Profit from Convergence – If the assets return to their historical correlation, the trader earns a profit.
Advantages
- Market-Neutral – Works in bullish, bearish, or sideways markets.
- Risk Management – Reduces exposure to overall market volatility.
- Statistical Edge – Based on historical price relationships rather than speculation.
Examples
- Coca-Cola (KO) vs. PepsiCo (PEP) – Since both companies operate in the beverage industry, traders may go long on KO and short on PEP if their historical price relationship diverges.
- Apple (AAPL) vs. Microsoft (MSFT) – Tech giants with strong correlation; traders may buy the underperforming stock and short the outperforming one.
- Gold vs. Silver – Precious metals often move together, making them a common pair for trading.
- Bank of America (BAC) vs. JPMorgan Chase (JPM) – Large financial institutions with similar market movements.
- Oil vs. Natural Gas – Energy commodities that tend to follow related price trends.
Pairs trading works best when assets have historical correlation and temporary price divergence.
Morgan Stanley analysts pioneered pairs trading in the 1980s and remains popular among quantitative traders today.
