#TradingPairs101 The Secret to Finding Profit in Pairs TradingQuants" is Wall Street's name for market researchers who use quantitative analysis to develop profitable trading strategies. In short, a quant combs through price ratios and mathematical relationships between companies or trading vehicles in order to divine profitable trading opportunities. During the 1980s, a group of quants working for Morgan Stanley struck gold with a strategy called the pairs trade. Institutional investors and proprietary trading desks at major investment banks have been using the technique ever since, and many have made a tidy profit with the strategy.
It is rarely in the best interest of investment bankers and mutual fund managers to share profitable trading strategies with the public, so the pairs trade remained a secret of the pros (and a few deft individuals) until the advent of the internet. Online trading opened the lid on real-time financial information and gave the novice access to all types of investment strategies. It didn't take long for the pairs trade to attract individual investors and small-time traders looking to hedge their risk exposure to the movements of the broader market.
Key Takeaways
Pairs trading involves betting on the price spread between two similar securities.
Pairs trades can be based on fundamental or technical factors, and these trades generally are held for shorter time horizons.
If the trader thinks the prices should converge, they will buy the relatively underpriced security and simultaneously sell the overpriced one.
What Is Pairs Trading?
Pairs trading has the potential to achieve profits through simple and relatively low-risk positions. The pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss.
The goal is to match two trading vehicles that are highly correlated, trading one long and the other short when the pair's price ratio diverges "x" number of standard deviations—x" is optimized using historical data. If the pair reverts to its mean trend, a profit is made on one or both of the positions.
Example of a Pairs Trade with Stocks
Traders can use either fundamental or technical data to construct a pairs-trading style. Our example here is technical in nature, but some traders use a P/E ratio or other fundamental factors to measure correlation and divergence.