What it means
The strategy starts with two assets that usually move together, such as two large companies in the same industry. If one becomes unusually cheap relative to the other, the investor buys the cheap one and short sells the expensive one, which means borrowing shares and selling them in the hope of buying them back lower.
The appeal is that the two legs largely offset each other when the whole market moves. If the sector falls 10%, the long position loses but the short position gains, so the investor is exposed mainly to the difference between the two.
That is why pairs trading is often described as market neutral. Practitioners track the price ratio or difference between the two assets over time.
When it moves well away from its usual range, they open the trade and close it when the gap returns to normal. The dollar value of each leg is usually matched so that neither side dominates.
The risks are real. The relationship may break permanently, for example if one company is hit by a scandal or takes over a rival, and the gap can keep widening while the investor pays borrowing costs on the short position.
Finance teams meet the idea outside trading desks too. The same logic of matching an exposure with an offsetting one underlies many hedges used by companies.
Costs deserve more attention than newcomers expect. Because both legs are traded, the investor pays commissions twice on opening and twice on closing, plus interest on borrowed shares and sometimes a fee to the lender.
A trade that looks attractive on paper can have most of its expected profit absorbed by those costs.
In practice
Real-world examples.
Example
A fund notices that two large supermarket chains usually trade at a similar price to earnings ratio. One has fallen well behind after a temporary supply problem. The fund buys the laggard and shorts the other, planning to close both when the valuations converge. The fund sets a stop-loss so that the trade closes automatically if the gap widens too far.
Example
An energy trader buys a crude oil contract for one delivery month and sells the contract for the following month. The trade profits if the price gap between the two months narrows, regardless of whether oil rises or falls. The trader sizes each leg equally in dollar terms so that neither dominates.
Example
A corporate treasurer is asked by the board why the firm holds a long position in a competitor's shares. The explanation is that the position is paired with a short in the sector index, so the firm benefits only if the competitor outperforms its peers. The board is told that the position is hedged but not risk free.
Formula
Calculation
Net profit = (long return x long amount) - (short stock return x short amount) - costs
An investor buys $50,000 of Alpha Corp and sells short $50,000 of Beta Corp, both in the same industry. Over two months Alpha rises 6% and Beta rises 2%. The long leg gains 0.06 x 50,000 = $3,000. The short leg loses 0.02 x 50,000 = $1,000 because Beta also rose. Borrowing and trading costs are $300. Net profit = 3,000 - 1,000 - 300 = $1,700, even though the whole sector went up.Case study
Seen in the real world.
Marlowe Quant Partners is an illustrative, fictional fund that ran a small pairs strategy across two banks of similar size. Historically their share prices moved within about 5% of each other, but after one bank announced a restructuring the gap widened to 14%.
The fund bought the cheaper bank and shorted the other in equal dollar amounts of $2,000,000 each. Over the next three months the gap narrowed to 6%, and the fund closed both legs for a combined gain of about $160,000 before costs.
The illustrative lesson is not that the trade was safe. Had the restructuring turned into a lasting problem, the gap could have kept widening, which is why the fund had set a loss limit before it started.
Watch out
Common mistakes.
- Assuming a pairs trade has no risk, when the two prices can drift further apart and the short leg carries borrowing costs.
- Choosing two assets that look similar on the surface but have no real link, so the gap never closes.
- Ignoring position size, which leaves one leg larger than the other and turns a neutral trade into a directional bet.
Questions
People also ask.
Does a pairs trade need a rising market to make money?
No, it can profit in rising or falling markets because it depends on the relative performance of the two assets.
What does market neutral mean?
It means the strategy is built so that overall market moves have little net effect, because gains on one leg offset losses on the other.
Can individuals do pairs trades?
Yes, if their broker allows short selling, though costs and margin requirements can make it harder to run at small size.
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