Pairs Trading is a market-neutral trading strategy where a long position is matched with a short position in a pair of highly correlated securities, such as two different ETFS, stocks, commodities, etc. Some people refer to it as a statistical arbitrage or convergence trading strategy.
The profit motive of pairs trading is to get long the security that is underperforming and to sell short the one that is overperforming. The trader's belief is that over time, the underperforming security will rise more in value in relation to the overperforming security. The pairs trade is ideally closed out when the positions in relation to each other return back to satistical norm.
A profit is realized on a pairs trade when the long position goes up more in value than the short position, or when the short position goes down in value more than the long position. In a perfect pairs trade scenario, the long position goes up in value and the short position goes down in value. What is intriguing about pairs trading is that profit is derived from the difference in price change between two securities, rather than the direction in which the two securities move (their prices can both go up, go down, or ones goes up and one goes down in price). So it is possible for pairs traders to profit during all kinds of market conditions, whether it be a bear or bull market or a sideways market, and in low or high volatility periods.
There are a few things to consider before doing a pairs trade. First is your buying power. Make sure you have enough buying power to do this type of trade. You have to buy a stock and short one so in essense you will be using double your normal buying power. Second is P&L volatility. The more buying power used in a position usually translates to bigger profit and loss swings. So be ready to stomach bigger than normal losses if the pairs trade goes the wrong way. Third is overnight risk. Pairs trades usually take longer than a day for your profit thesis to successfully materialize. So it's likely that you will have to carry the position for days or even weeks.
- Hubert Tsai