Pairs trading is a market-neutral strategy that profits from the relative performance between two correlated stocks. By going long one stock and short another, traders can profit regardless of overall market direction, focusing on the spread between the two securities.
What is Pairs Trading?
Pairs trading involves simultaneously buying one stock and shorting another related stock. The key principles are:
- Find two stocks that historically move together (high correlation)
- When the spread between them widens abnormally, bet on convergence
- Buy the underperformer and short the outperformer
- Profit when the spread returns to normal
Key concept: Pairs trading is market neutral, meaning it can profit in bull, bear, or sideways markets. You are betting on the relationship between two stocks, not market direction.
Why Pairs Trading Works
The strategy exploits temporary mispricings:
- Correlated stocks should move together over time
- Short-term divergences create opportunities
- Mean reversion of the spread is statistically likely
- Hedged position reduces market risk
Finding Suitable Pairs
Same Sector Pairs
Companies in the same industry often move together:
- Coca-Cola (KO) and PepsiCo (PEP)
- Exxon (XOM) and Chevron (CVX)
- Visa (V) and Mastercard (MA)
- Home Depot (HD) and Lowes (LOW)
Statistical Requirements
- Correlation: Should be above 0.80 over the past year
- Cointegration: The spread should be mean-reverting
- Similar beta: Stocks should have similar market sensitivity
- Similar market cap: Comparable company sizes work better
Testing the Pair
- Calculate the historical correlation
- Chart the price ratio or spread over time
- Verify the spread oscillates around a mean
- Check that divergences historically revert
Entry Rules for Pairs Trading
The Spread Calculation
There are several ways to measure the spread:
- Price ratio: Stock A price / Stock B price
- Price difference: Stock A price - Stock B price
- Z-score: How many standard deviations from the mean
Z-Score Entry Method
The most common approach:
- Calculate the spread between the two stocks
- Calculate the mean and standard deviation of the spread (20-60 day period)
- Calculate the Z-score: (Current spread - Mean) / Standard deviation
- Enter when Z-score exceeds +/- 2
Z-Score Entry Example
Pair: Coca-Cola (KO) and PepsiCo (PEP)
Historical spread (KO/PEP ratio): Mean = 0.38, StdDev = 0.02
Current ratio: 0.42 (KO has outperformed)
Z-score: (0.42 - 0.38) / 0.02 = +2.0
Trade: Short KO (outperformer), Long PEP (underperformer)
Expectation: Ratio will revert toward 0.38
Entry Rules Summary
- Long spread: When Z-score drops below -2 (buy stock A, short stock B)
- Short spread: When Z-score rises above +2 (short stock A, buy stock B)
- Some traders use -1.5/+1.5 for more frequent trades
- Others use -2.5/+2.5 for higher probability setups
Position Sizing for Pairs
Dollar-Neutral Sizing
Match the dollar value of both sides:
- If going long $10,000 of Stock A
- Go short $10,000 of Stock B
- This creates a market-neutral position
Beta-Neutral Sizing
Adjust for different betas:
- If Stock A has beta 1.2 and Stock B has beta 0.8
- Adjust position sizes to neutralize market exposure
- This requires more calculation but provides better hedging
Position Sizing Example
Account: $100,000, Risk limit: $10,000 per pair
KO at $60, PEP at $160
Dollar-neutral approach:
Long 62 shares of PEP ($9,920)
Short 165 shares of KO ($9,900)
Total exposure: ~$20,000, but market-neutral
Exit Rules for Pairs Trading
Profit Target Exits
- Mean reversion: Exit when Z-score returns to 0
- Partial exit: Take half off at Z-score 1, rest at 0
- Opposite extreme: Exit when Z-score reaches opposite side
Stop Loss Exits
- Z-score stop: Exit if Z-score reaches +/- 3 or 4
- Percentage stop: Exit if loss exceeds 5-10% of position
- Time stop: Exit if position does not work within 20-30 days
Correlation Breakdown Exit
- Monitor the correlation during the trade
- Exit if correlation drops significantly
- Fundamental changes may break the relationship
Complete Pairs Trade
Entry: Z-score at +2.2
Trade: Short KO, Long PEP (dollar-neutral)
Day 5: Z-score drops to +1.0 (partial profit)
Day 12: Z-score returns to 0 (close remaining position)
Result: Spread contracted, profit on both legs
Risk Management for Pairs
Risks to Monitor
- Correlation breakdown: The relationship may change
- Fundamental divergence: News may affect one stock permanently
- Short squeeze risk: The short side may spike
- Execution risk: Slippage on entry and exit
Risk Mitigation
- Use stop losses on the spread
- Diversify across multiple pairs
- Avoid pairs with upcoming earnings on different dates
- Monitor for news that could affect the relationship
Pairs Trading Checklist
- Is the correlation above 0.80?
- Does the spread historically mean-revert?
- Is the current Z-score at an extreme (+/- 2)?
- Are positions dollar or beta neutral?
- Is there a clear exit plan (target and stop)?
- Are there any upcoming catalysts that could break the correlation?
Common Pairs Trading Mistakes
- Trading pairs with low correlation
- Ignoring fundamental changes that break the relationship
- Not using dollar-neutral or beta-neutral sizing
- Holding too long waiting for perfect mean reversion
- Trading around earnings when stocks report on different dates
- Using too small a lookback period for statistics
- Ignoring transaction costs and borrowing costs for shorts
Advantages of Pairs Trading
- Market neutral - profit in any market condition
- Reduced volatility compared to directional trading
- Statistically based entries and exits
- Natural hedge against market crashes
Disadvantages of Pairs Trading
- Requires short selling capability
- Borrowing costs reduce profits
- Correlations can break unexpectedly
- Requires more capital (two positions per trade)
Track Your Pairs Trades
Pro Trader Dashboard helps you monitor the performance of your pairs trading strategies.
Summary
Pairs trading is a market-neutral strategy that profits from the relative performance of two correlated stocks. By going long the underperformer and short the outperformer when the spread reaches an extreme, traders bet on mean reversion. The key is finding highly correlated pairs, using proper position sizing to remain market neutral, and having clear exit rules. While pairs trading requires short selling and more capital, it offers the advantage of profiting regardless of market direction and provides a natural hedge against market risk.
Learn more: sector trading and delta neutral trading.