Pairs Trade
A pairs trade is a market neutral strategy that goes long one asset and short another related asset. The goal is to profit from the relative performance between the two rather than the overall market direction.
Core idea
The trader identifies two assets that historically move together. When their spread diverges beyond a threshold, the trader buys the underperformer and sells the outperformer, expecting the spread to revert.
Example
Two stocks in the same sector normally trade with a stable price ratio. The ratio widens when one stock drops sharply. A trader buys the weaker stock and sells the stronger stock, aiming to profit as the ratio returns to normal.
Key risks
- Correlations can break during regime shifts.
- One company can face unique news that changes the relationship.
- Funding and borrow costs can reduce returns.
Practical notes
Pairs trades require robust statistical testing and disciplined risk limits because spreads can remain diverged for long periods.
Practical checklist
- Define the time horizon for Pairs Trade and the market context.
- Identify the data inputs you trust, such as price, volume, or schedule dates.
- Write a clear entry and exit rule before committing capital.
- Size the position so a single error does not damage the account.
- Document the result to improve repeatability.
Common pitfalls
- Treating Pairs Trade as a standalone signal instead of context.
- Ignoring liquidity, spreads, and execution friction.
- Using a rule on a different timeframe than it was designed for.
- Overfitting a small sample of past examples.
- Assuming the same behavior in abnormal volatility.
Data and measurement
Good analysis starts with consistent data. For Pairs Trade, confirm the data source, the time zone, and the sampling frequency. If the concept depends on settlement or schedule dates, align the calendar with the exchange rules. If it depends on price action, consider using adjusted data to handle corporate actions.
Risk management notes
Risk control is essential when applying Pairs Trade. Define the maximum loss per trade, the total exposure across related positions, and the conditions that invalidate the idea. A plan for fast exits is useful when markets move sharply.
Variations and related terms
Many traders use Pairs Trade alongside broader concepts such as trend analysis, volatility regimes, and liquidity conditions. Similar tools may exist with different names or slightly different definitions, so clear documentation prevents confusion.
Practical checklist
- Define the time horizon for Pairs Trade and the market context.
- Identify the data inputs you trust, such as price, volume, or schedule dates.
- Write a clear entry and exit rule before committing capital.
- Size the position so a single error does not damage the account.
- Document the result to improve repeatability.
Common pitfalls
- Treating Pairs Trade as a standalone signal instead of context.
- Ignoring liquidity, spreads, and execution friction.
- Using a rule on a different timeframe than it was designed for.
- Overfitting a small sample of past examples.
- Assuming the same behavior in abnormal volatility.
Data and measurement
Good analysis starts with consistent data. For Pairs Trade, confirm the data source, the time zone, and the sampling frequency. If the concept depends on settlement or schedule dates, align the calendar with the exchange rules. If it depends on price action, consider using adjusted data to handle corporate actions.
Risk management notes
Risk control is essential when applying Pairs Trade. Define the maximum loss per trade, the total exposure across related positions, and the conditions that invalidate the idea. A plan for fast exits is useful when markets move sharply.
Variations and related terms
Many traders use Pairs Trade alongside broader concepts such as trend analysis, volatility regimes, and liquidity conditions. Similar tools may exist with different names or slightly different definitions, so clear documentation prevents confusion.
Practical checklist
- Define the time horizon for Pairs Trade and the market context.
- Identify the data inputs you trust, such as price, volume, or schedule dates.
- Write a clear entry and exit rule before committing capital.
- Size the position so a single error does not damage the account.
- Document the result to improve repeatability.
Common pitfalls
- Treating Pairs Trade as a standalone signal instead of context.
- Ignoring liquidity, spreads, and execution friction.
- Using a rule on a different timeframe than it was designed for.
- Overfitting a small sample of past examples.
- Assuming the same behavior in abnormal volatility.
Data and measurement
Good analysis starts with consistent data. For Pairs Trade, confirm the data source, the time zone, and the sampling frequency. If the concept depends on settlement or schedule dates, align the calendar with the exchange rules. If it depends on price action, consider using adjusted data to handle corporate actions.