Definition
Pairs Trading
Pairs trading is a market-neutral strategy that goes long one security and short a related one when their historical price relationship diverges, betting that the spread will revert to its mean.
A classic Indian example might pair two banks or two cement companies whose prices usually move together. When the ratio widens beyond its normal range, the trader buys the laggard and sells the leader, profiting if the relationship reconverges, regardless of the broad market's direction.
Pairs trading is the simplest form of statistical arbitrage and relies on mean reversion in the spread. In India, the short leg can be implemented via futures or, for permitted stocks, securities lending and borrowing, since intraday-only short selling limits multi-day cash shorts in the cash segment.
Related terms
- Statistical ArbitrageStatistical arbitrage is a class of quantitative strategies that exploit short-term, statistically predictable price relationships across many securities, holding diversified long and short positions to harvest small mispricings.
- Mean Reversion StrategyA mean reversion strategy assumes that prices or spreads that deviate from a historical average will tend to return to it, so it sells what has risen sharply and buys what has fallen.
- CointegrationCointegration is a statistical property where two or more non-stationary price series move together over the long run such that a particular linear combination of them is stationary and mean-reverting.
- Market-Neutral StrategyA market-neutral strategy balances long and short positions so that the portfolio has little or no net exposure to broad market movements, isolating the manager's stock-selection skill.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.