Quick definition Pairs trading is identifying two securities with strong historical correlation and trading them together, betting on convergence when they diverge. What it is Pairs trading selects two securities (e.g., Coca-Cola and Pepsi) that historically move together. When they diverge (one outperforms), the strategy bets they will converge back. The strategy goes long the underperformer and short the outperformer, betting on convergence. If they converge, both sides of the trade profit. Why it matters Pairs trading is market-neutral: it hedges market risk by going long one security and short another. It profits from relative value, not market direction. Pairs trading is popular with hedge funds because it profits regardless of market direction. Pair selection Effective pairs trading requires careful pair selection. The two securities must be: - Highly correlated historically - Unlikely to have permanent divergence - Liquid enough to trade Good pairs include competitors (Coke vs. Pepsi), sectors (banks in the same region), or index constituents. Practical example Historical data shows Airline A and Airline B stock prices have a very high correlation. One day, Airline A announces good earnings and jumps 5 percent. Airline B doesn't move. A pairs trader shorts Airline A and buys Airline B, betting they will converge. If Airline B rises to match Airline A's move, both sides profit. Risks Pairs trading fails when the historical relationship breaks. If Airline B has structural problems different from Airline A, their prices might not converge. Hedge ratios Pairs traders use statistical methods to determine the correct hedge ratio (how much of each security to buy/sell) to minimize market exposure. See also - Statistical Arbitrage - Mean Reversion - Market Neutral - Correlation
