Pairs Trade

A pairs trade is a trading strategy that involves matching a long position with a short position in two stocks with a high correlation.

Pairs trading was first introduced in the mid-'80s by a group of technical analyst researchers from Morgan Stanley. The concept uses statistical and technical analysis to seek out potential market-neutral profits.

Market-neutral strategies are a key aspect of pairs trade transactions. Market-neutral strategies involve long and short positions in two different securities with a positive correlation. The two offsetting positions form the basis for a hedging strategy that seeks to benefit from either a positive or negative trend.

A pairs trade strategy is based on the historical correlation of two securities. The securities in a pairs trade must have a high positive correlation, which is the primary driver behind the strategy’s profits. A pairs trade strategy is best deployed when a trader identifies a correlation discrepancy. Relying on the historical notion that the two securities will maintain a specified correlation, the pairs trade can be deployed when this correlation falters.

When pairs from the trade deviate, an investor would seek to take a dollar matched long position in the underperforming security and sell short the outperforming security. If the securities return to their historical correlation, a profit is made from the convergence of the prices.

When a pairs trade performs as expected, the investor profits and also mitigates potential losses that would have occurred in the process. Profits are generated when the underperforming security regains value and the outperforming security’s price deflates. The net profit is the total gained from the two positions.

There are a number of limitations for pairs trading. One is that the pairs trade relies on a high statistical correlation between two securities. Most pairs trades will require a correlation of 0.80 which can be challenging to identify. Second, while historical trends can be accurate, past prices are not always indicative of future trends. Requiring only a correlation of 0.80 can also decrease the likelihood of the expected outcome.

To illustrate the potential profit, consider Stock A and Stock B which have a high correlation of 0.95. The two stocks deviate from their historical trending correlation in the short term with a correlation of 0.50. The arbitrage trader steps in to take a dollar matched long position on underperforming Stock A with a short position on outperforming Stock B. The stocks converge returning to their 0.95 correlation over time. The trader profits from the long position and closed short position.

For more on pairs trading see also: Guide to Pairs Trading and The Secret To Finding Profit In Pairs Trading.