1. Pairs Trading: Introduction
  2. Pairs Trading: Market Neutral Investing
  3. Pairs Trading: Correlation
  4. Arbitrage and Pairs Trading
  5. Fundamental and Technical Analysis for Pairs Trading
  6. Pairs Trade Example
  7. Pairs Trading: Risks
  8. Disadvantages of Pairs Trading
  9. Advantages of Pairs Trading
  10. Pairs Trading: Conclusion

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.
Pairs trading’s origin is generally credited to a group of computer scientists, mathematicians and physicists assembled by Wall Street’s Morgan Stanley & Co. in the early to mid-1980s. The team, which included computer scientists Gerry Bamberger and David Shaw, and quant trader Nunzio Tartaglia, was brought together to study arbitrage opportunities in the equities markets, employing advanced statistical modeling and developing an automated trading program to exploit market imbalances.
Central to their research was the development of quantitative methods for identifying pairs of securities whose prices exhibited similar historical price movements, or that were highly correlated. While the team’s resulting black box was traded successfully in 1987 – the group made a reported $50 million profit for Morgan Stanley – the next two years of trading saw poor enough results that in 1989 the group disbanded.
Over the years, pairs trading has gained modest attention among individual, institutional and hedge fund traders as a market-neutral investment strategy. This is largely due to the advent of the Internet and advancements in trading technology. These two factors have helped level the playing field for individual investors, making real-time market data and powerful tools both available and affordable to more than just the institutional traders. True, the large hedge funds and institutional traders still have advantages (for example, robust proprietary systems and economies of scale). However, today’s market participants – whether retails traders or a team of highly-skilled mathematicians in a quant shop – have access to real-time financial market data, direct access trading platforms, advanced computer modeling and the ability to automate complex trading strategies.
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. Here, we introduce pairs trading, market-neutral investments, arbitrage and provide an example of a pairs trade.

Pairs Trading: Market Neutral Investing
Related Articles
  1. Trading

    The Secret To Finding Profit In Pairs Trading

    Read about a market-neutral trading strategy using relatively low-risk positions.
  2. Investing

    Getting Positive Results With Market-Neutral Funds

    Find out how these mutual funds can add some flavor to your bland portfolio.
  3. Investing

    Arbitrage Squeezes Profit From Market Inefficiency

    This influential strategy capitalizes on the relationship between price and liquidity.
  4. Trading

    Quant Strategies - Are They For You?

    Using the power of modern computers and the input of many financial experts, these models automatically execute trades for you.
Frequently Asked Questions
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The concept of CAGR is relatively straightforward and requires only three primary inputs: an investments beginning value, ...
  2. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors with insight into how efficiently a company (or more specifically, ...
  3. What is the difference between Communism and Socialism?

    Learn how some countries are incorporating socialist methods into capitalism.
  4. What's the difference between a stop and a limit order?

    A limit order is an order that sets the maximum or minimum at which you are willing to buy or sell a particular stock. With ...
Trading Center