Pair Trading
Pair trading is a market-neutral quantitative strategy that exploits the relative price relationship between two correlated assets.
Core Idea
Two assets that historically move together tend to revert to a stable relationship.
When the relationship deviates:
buy the underperformer and short the overperformer
Setup
Choose two correlated assets:
- Stock A
- Stock B
Define a relationship:
- price ratio
- spread
- statistical model (e.g. regression residual)
Trade Logic
When A becomes expensive relative to B:
- Short A
- Long B
When A becomes cheap relative to B:
- Long A
- Short B
Goal
Profit from:
mean reversion of the price relationship, not direction of the market
Market Neutrality
Pair trading aims to reduce exposure to overall market movement:
- One long position
- One short position
So:
returns depend on relative mispricing, not market direction
Spread Concept
The key variable is the spread:
Where:
- ( ) adjusts for scale or hedge ratio
Entry / Exit Signal
- Enter trade when spread deviates significantly from mean
- Exit when spread reverts back
Why it works
Pair trading relies on:
- statistical correlation
- temporary mispricing
- mean reversion behavior
Risk Considerations
- correlation can break down
- structural regime changes
- execution + transaction costs
- model mis-specification
Connection to Portfolio Theory
Pair trading is a special case of portfolio optimization:
- Two-asset hedge portfolio
- Minimizes market exposure
- Optimizes relative return vs risk
One-line Summary
Pair trading is a market-neutral strategy that profits by betting on the convergence of the price relationship between two historically correlated assets.