Pairs trading is a market-neutral trading strategy that matches a long position with a short position in a pair of highly correlated instruments such as two stocks, exchange-traded funds (ETFs), currencies, commodities or options.
Pairs traders wait for weakness in the correlation, and then go long on the under-performer while simultaneously going short on the over-performer, closing the positions as the relationship returns to its statistical norm.
The strategy’s profit is derived from the difference in price change between the two instruments, rather than from the direction in which each moves.
Therefore, a profit can be realized if the long position goes up more than the short, or the short position goes down more than the long (in a perfect situation, the long position will rise and the short position will fall, but this is not a requirement for making a profit).
It is possible for pairs traders to profit during a variety of market conditions, including periods when the market goes up, down or sideways, and during periods of either low or high volatility.
Over the years, pairs trading has gained modest attention among individual, institutional and hedge fund traders as a market-neutral investment strategy.
Using technology – as well as drawing on fundamentals, probabilities, statistics and technical analysis – pairs traders attempt to identify relationships between two instruments, determine the direction of the relationship and execute trades based on the data presented.