What Is Pairs Trading? Strategy, Benefits, and Risks

What Is Pair Trading?

Pair trading is a market-neutral trading strategy involving buying one asset while selling another highly correlated asset. The goal is to profit from temporary price differences between the two assets rather than predicting the overall market direction.

This trading strategy is based on the idea that some assets tend to move together over time due to fundamental or market-related factors. However, short-term price fluctuations can create temporary imbalances between them. When this happens, traders use pair trading to take advantage of these price differences, assuming that the two assets will eventually return to their usual relationship.

For example, consider two companies in the same industry, like Coca-Cola (KO) and Pepsi (PEP). Historically, their stock prices tend to move similarly because they operate in the same sector, face similar market conditions, and compete for the same customers.

But if Coca-Cola's stock suddenly rises while Pepsi's remains the same, a trader might assume that the price difference is temporary. They would short sell Coca-Cola (betting that its price will go down) and buy Pepsi (betting that its price will go up).

When the gap between them closes, the trader can exit both positions with a profit.

Pair trading can be applied to various markets, including:

• Stocks: Trading similar companies (e.g., Ford vs. General Motors).

• Forex: Using currency pairs like EUR/USD and GBP/USD.

• Commodities: Trading assets like gold vs. silver.

• Crypto: Pairing highly correlated cryptocurrencies like Bitcoin and Ethereum.

How Pair Trading Works

Pair trading involves finding the right pair, identifying a trading signal, executing the trade, and managing risk.

Step 1: Selecting the Right Asset Pair

The first step in pair trading is choosing two assets that have a strong historical correlation. That means their prices tend to move together over time. These pairs usually belong to the same industry, sector, or asset class.

Here’s some examples:

• Stocks: Coca-Cola (KO) and Pepsi (PEP), Ford (F) and General Motors (GM).

• Forex: EUR/USD and GBP/USD, AUD/USD and NZD/USD.

• Commodities: Gold and silver, crude oil and natural gas.

• Crypto: Bitcoin (BTC) and Ethereum (ETH), Litecoin (LTC) and Bitcoin Cash (BCH).

Traders use statistical tools like correlation coefficients and cointegration tests to confirm a strong relationship between the two assets. A high correlation (close to +1) suggests that the two assets move in sync, making them suitable for pair trading.

Step 2: Identifying a Trading Signal

Once a trader selects a pair, they monitor the price relationship between the two assets. The goal is to identify moments when their usual correlation temporarily breaks, creating a trading opportunity.

The most common approach is based on mean reversion, which assumes that prices will return to their normal relationship after diverging.

Here’s what to look for:

• A widening price gap: One asset moves up while the other lags behind.

• Z-Score Analysis: Measures how far the price spread has deviated from the average.

• Moving Averages: Identifies potential entry points when one asset becomes overbought or oversold.

For example, if stock A and stock B usually move together, but stock A suddenly spikes while stock B remains stable, traders assume stock A is overbought and stock B is undervalued. They will short stock A and go long on stock B, expecting the price gap to close.

Step 3: Executing the Trade

After identifying a trading signal,, traders enter two simultaneous positions:

• Long position (buying the weaker asset): This assumes the undervalued asset will rise.

• Short position (selling the stronger asset): This assumes the overvalued asset will decline.

Because both positions are placed simultaneously, market-wide price movements have less impact on the overall trade. Instead, profits come from the price gap returning to normal rather than the market moving in a specific direction.

Step 4: Monitoring and Closing the Trade

Pair trades are typically closed when the price relationship between the two assets normalizes. Traders set exit conditions based on:

• The spread returning to historical averages.

• A predefined stop-loss if the trade moves against expectations.

• A take-profit level when the desired profit is reached.

For instance, if a trader shorted Coca-Cola and went long on Pepsi, they would close both positions once Coca-Cola's price drops and Pepsi's price rises back to their usual relationship.

Pairs Trading vs. Statistical Arbitrage

While pairs trading is a well-known market-neutral strategy, it is often confused with statistical arbitrage. Both approaches use statistical relationships to identify trading opportunities, but they differ in complexity, execution, and the number of assets involved.

Statistical arbitrage is a quantitative trading strategy that relies on statistical and mathematical models to identify short-term mispricings across multiple assets. Unlike pairs trading, which focuses on just two assets, statistical arbitrage typically involves a basket of securities and is often implemented through algorithmic and high-frequency trading (HFT).

The table below summarizes the key differences between pair trading and statistical arbitrage:

Pairs Trading in Forex

Pairs trading is also widely used in the forex market, where traders take advantage of price differences between two highly correlated currency pairs. Instead of trading a single currency pair directionally, traders go long on one pair and short on another to profit from their relative price movements.

Commonly traded forex pairs for this strategy include:

• Positively Correlated Pairs: EUR/USD and GBP/USD, AUD/USD and NZD/USD.

• Negatively Correlated Pairs: EUR/USD and USD/CHF, GBP/USD and USD/JPY.

Traders monitor the spread between the two pairs, using indicators like the correlation coefficient, Z-score, and Bollinger Bands to identify trading signals.

Benefits and Risks of Pairs Trading

Pairs trading offers a structured, market-neutral approach to trading, making it attractive to many traders. However, like any strategy, it comes with both advantages and potential risks.

Benefits of Pairs Trading

Here are the benefits of pair trading:

Market Neutrality

Pairs trading is a hedged strategy, meaning traders are less exposed to overall market movements. Since one position is long and the other is short, profits depend on the relative performance of the two assets rather than the market's direction.

Lower Risk Compared to Directional Trading

Because traders hold both a long and a short position, broad market fluctuations have a smaller impact compared to trading a single asset. This can help protect against unexpected market downturns.

Works in All Market Conditions

Pairs trading can be used in bullish, bearish, and sideways markets because it focuses on the relationship between two assets rather than predicting overall price movements.

Diversification and Hedging

Traders can use pairs trading to hedge risks by selecting assets from similar industries or sectors. This diversification helps reduce exposure to sector-specific risks and macroeconomic events.

Quantifiable and Backtestable

Pairs trading relies on statistical analysis, making it easy to backtest using historical data. Traders can refine their strategies before applying them in real-time markets.

Risks of Pairs Trading

Here are the risks of pair trading:

Breakdown of Correlation

A key assumption in pairs trading is that two assets will maintain a historical correlation. However, correlations can break down due to fundamental shifts, economic events, or industry changes, making the trade invalid.

Execution and Liquidity Risks

Pairs trading requires opening two positions simultaneously. If one leg of the trade executes but the other experiences slippage or liquidity issues, the trader could face an unbalanced position and unintended exposure.

Market Events and External Shocks

Unexpected news, earnings reports, interest rate changes, or geopolitical events can impact the assets in a pair differently, causing losses even if the original correlation was strong.

Overfitting in Backtesting

While backtesting can refine strategies, traders risk over-optimizing models for historical data that may not hold up in live trading. Market conditions change, making past patterns unreliable.

Tips for a Successful Pairs Trading Strategy

Here are some tips to maximize success in pairs trading:

• Choose Highly Correlated Pairs: Ensure the assets have a strong historical relationship to increase the chances of mean reversion.

• Use Statistical Tools: Apply correlation analysis, Z-score, and Bollinger Bands to identify trading opportunities.

• Set Stop-Loss and Take-Profit Levels: Manage risk by defining exit points to protect against unexpected market moves.

• Regularly Reassess Correlations: Market conditions change, so continuously monitor and adjust your asset pairs.

• Avoid Overleveraging: Using too much leverage can amplify losses if the trade moves against expectations.

• Backtest Before Trading Live: Test your strategy with historical data to refine entry and exit points before using real capital.

Conclusion

Pairs trading is a versatile market-neutral strategy that allows traders to profit from price discrepancies between two correlated assets while minimizing exposure to overall market trends. By carefully selecting asset pairs, using statistical analysis, and applying proper risk management, traders can improve their chances of success. However, like any trading strategy, pairs trading comes with risks, including correlation breakdowns and execution challenges.