PAIRS TRADING
Overview
Buy the stronger stock and short the weaker stock in the same sector, betting the price gap will narrow. Market neutral by design — you profit from the relative performance difference, not overall market direction. Used by hedge funds to extract alpha in any market environment.
Setup
- 1.Identify two highly correlated stocks in the same sector (e.g., Visa vs. Mastercard, Exxon vs. Chevron).
- 2.Calculate the historical spread ratio and set entry/exit thresholds (typically 1-2 standard deviations from mean).
- 3.When the spread widens abnormally, buy the underperformer and short the outperformer.
- 4.Dollar-neutral the pair: equal dollar values on each side to be market-neutral.
- 5.Exit when the spread reverts to the historical mean or after a set time period (30-60 days).
Max profit
The spread returning fully to the historical mean — typically 5-15% on each leg.
Max loss
If the spread continues to widen (fundamental divergence rather than temporary dislocation), losses on both legs compound. Use stop-losses based on spread levels.
Breakeven
The spread at entry plus transaction costs on both sides.
When to use
In any market environment — the strategy is market neutral. Best when the spread has clear statistical support for mean reversion and no obvious fundamental reason for permanent divergence.
When to avoid
When one company has a material fundamental change (earnings disaster, fraud, acquisition target) that justifies permanent spread widening. Never assume reversion without checking the news.