The pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy. The pair trading was pioneered by Gerry Bamberger and later led by Nunzio Tartaglia’s quantitative group at Morgan Stanley in the 1980s.

The strategy monitors performance of two historically correlated securities. When the correlation between the two securities temporarily weakens, i.e. one stock moves up while the other moves down, the pairs trade would be to short the outperforming stock and to long the underperforming one, betting that the “spread” between the two would eventually converge. The divergence within a pair can be caused by temporary supply/demand changes, large buy/sell orders for one security, reaction for important news about one of the companies, and so on.

Pairs trading strategy demands good position sizing, market timing, and decision making skill. Although the strategy does not have much downside risk, there is a scarcity of opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity.

 

There are generally two types of pairs trading: statistical arbitrage convergence/divergence trades, and fundamentally-driven valuation trades. In the former, the driving force for the trade is an aberration in the long-term spread between the two securities, and to realize the mean-reversion back to the norm, you short one and go long the other. The trick is to find the pairs, and for the relationship to hold.

 

The other form of pairs trading would be more fundamentally-driven variation, which is the purvey of most market-neutral hedge funds: in essence they short the most overvalued stock(s) and go long the undervalued stock(s). It’s normal to “pair” up stocks by having the same number per sector on the long and short side.

 

Simplified Example

 

ICICIBANK and AXISBANK are different banks doing similar business.  Historically, the two banks have shared similar dips and highs, depending on the market conditions. If the price of ICICIBANK were to go up a significant amount while AXISBANK stayed the same, a pairs trader would buy AXISBANK stock and sell ICICIBANK stock, assuming that the two banks would later return to their historical balance point. If the price of AXISBANK rose to close that gap in price, the trader would make money on the AXISBANK stock, while if the price of ICICIBANK fell, he would make money on having shorted the ICICIBANK stock.

The reason for the deviated stock to come back to original value is itself an assumption. It is assumed that the pair will have similar business idea as in the past during the holding period of the stock.

 

Further Reading