Pair Trade takes advantage of the deviation in valuation of stocks due to the dynamic nature of the market. Key to spreading the risk is an assumption that the pair will have similar business idea as in the past during the holding period of the stock and will return to historic average levels.
The concept of Pair Trading came into existence to mitigate the inherent risks in the market. Having said that, Pair Trading has following risks.
Stock Specific Risk
Whilst pairs traders enjoy significantly reduced market risk and sector risk, individual stock risk remains. One example would be a company that receives a takeover offer. Generally under these circumstances that stock will rally strongly, but other stocks in that sector are not likely to have similar moves. If that stock is held short in the pairs trade the risk of a loss is heightened.
Pairs Drift
Whilst pairs trades are implemented on the basis of extensive historical analysis and testing that indicates a high probability that the stock prices are likely to return close to their historical relationship, there are no guarantees. Inevitably, some stock pairs will diverge, and it is possible even on a trade of highly correlated pairs to lose on both legs of the trade.
Model Risk
Risk that occurs when the model used to create the strategy does not perform as expected. This can be due to a number of factors ranging from inaccurate research to flawed logic or calculations.