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Pairs trading

Pairs trading is a market-neutral strategy of simultaneously taking a long position in one stock and a short position in a related stock, betting that the two will converge in relative value. By hedging one stock against another, the pairs trader removes market risk, leaving only the relative-value bet.

For broader statistical arbitrage, see statistical arbitrage. For short-selling mechanics, see short-selling. For relative-value strategies, see merger arbitrage.

How pairs trading works

The setup:

Two related stocks — perhaps two automakers, two retailers, or two airlines — are typically correlated. If one moves 10%, the other usually moves 8–9%. However, at times, one becomes relatively overvalued compared to the other.

The trade:

  1. Identify mispricing. Stock A is trading at 12x earnings; Stock B (similar company) is trading at 15x earnings. Stock B is relatively expensive.
  2. Long the cheap stock. Buy Stock A at $50.
  3. Short the expensive stock. Short Stock B at $75.
  4. Size for hedge. If the beta relationship is 1:1, equal dollar amounts. If B is more volatile, size accordingly.
  5. Wait for convergence. Stock A rallies to $52; Stock B falls to $73. The relative value gap has narrowed.
  6. Exit. Close both positions, capturing the convergence profit.

The math: If Stock A gains $2 and Stock B loses $2, the gross profit is $4 on your combined position, regardless of whether the market rallied or crashed.

Advantages

  • Market-neutral. A bear market that crashes 30% affects both stocks similarly; the hedge is intact.
  • Lower volatility. By removing market risk, the portfolio volatility is lower than holding the long position alone.
  • Identifies mispricing. Pairs traders must find genuine relative-value divergences, requiring deep fundamental or quantitative analysis.

Challenges

  1. Convergence may fail. The cheap stock may get cheaper; the expensive stock may get more expensive. The divergence can persist for years.
  2. Execution costs. Going long one stock and short another incurs two sets of transaction costs.
  3. Short-selling risk. Shorting is risky — unlimited loss potential. A short position in Stock B that rallies 20% against the hedge can cause significant losses.
  4. Correlation breaks. The historical correlation between the two stocks may break (one may face unique challenges; sector rotation may favor one). The hedge fails.
  5. Margin and borrow costs. Short-selling requires margin and borrow costs (lending fees), eroding profits.

See also

Wider context