Pairs Trading Strategy

Pairs trading profits from relative price movements between correlated stocks.

What is Pairs Trading?

Concept

• Long one stock, short another
• Both in same sector/industry
• Profit from relative movement
• Market-direction neutral

Why It Works

• Correlated stocks tend to move together
• Temporary divergences create opportunities
• Mean reversion is reliable
• Reduces market risk

Finding Pairs

Good Pair Characteristics

• Same sector and industry
• Similar business models
• High historical correlation (0.8+)
• Similar market cap
• Examples: Coca-Cola/Pepsi, Visa/Mastercard

Correlation Analysis

• Calculate rolling correlation
• Look for consistently high correlation
• Minimum 1 year of data
• Check correlation is stable

Trading the Pair

Measuring Divergence

• Price ratio between two stocks
• Z-score of the ratio
• When Z-score exceeds 2: Entry signal
• When Z-score returns to 0: Exit

Entry Rules

• Z-score above 2: Short the outperformer, long the underperformer
• Z-score below -2: Long the outperformer, short the underperformer
• Equal dollar amounts on each side

Exit Rules

• Z-score returns to 0 (mean)
• Maximum hold time reached
• Stop loss at Z-score of 3
• Correlation breaks down

Risk Management

Position Sizing

• Equal dollar value on each leg
• Adjust for beta difference
• Risk 1-2% total on the pair
• Account for potential divergence

When Pairs Fail

• Fundamental change in one company
• Merger or acquisition
• Regulatory change
• Sector disruption

Tools

• Statistical software for correlation
• Pair trading screeners
• Z-score calculators
• Position tracking spreadsheet

Key Takeaways

1. Pairs trading reduces market risk
2. Choose highly correlated pairs
3. Use Z-score for entry/exit timing
4. Equal dollar weights on each side
5. Have stop loss for when correlation breaks