Definition of 'Pairs Trade'
This is best illustrated with an example: Say stocks A and B are valued at $50 each and anytime stock A changes price stock B changes price by the same amount. Then, one day, stock A rises by $1 and stock B drops by $1 so that the prices are: A: $51 and B: $49. The Pairs Trade would be to buy B and sell the same quantity of A in the anticipation that they will return to parity. When this happens you reverse out the trade and your profit should be $2 per share.
When does this go wrong? (i.e. when will you lose money?)
The stocks may have diverged and broken their pair relationship for good because one of the companies has become more attractive/profitable and/or the other company has run into trouble.
The pairs trade is also know as pair trading. This is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy.
The strategy monitors performance of two historically correlated securities. When the correlation between the two securities temporarily weakens. For example when one stock moves up while the other moves down, the pairs trade would be to short the outperforming stock and to long the under-performing one, betting that the "spread" between the two would eventually converge. The divergence within a pair can be caused by temporary supply/demand changes, large buy/sell orders for one security, reaction for important news about one of the companies, and so on.
Pairs trading strategy demands good position sizing, market timing, and decision making skill. Although the strategy does not have much downside risk, there is a scarcity of opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity.
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