Pairs trading is a market-neutral trading tactic that allows investors to use the historical performance of stocks to place long and short bets to make big profits.
Pairs trading was first used in the mid-1980s as a way of using technical and statistical analysis as a way to find potential profits. It remained the province of Wall Street professionals until the internet opened online trading and real-time financial information to the public. Before long, there were seasoned amateur investors using pairs trades to make money, while managing their risk exposure.
What Is Pairs Trading?
Pairs trading is a day trading strategy in which an investor takes a long position and a short position in two securities that have shown a high historical correlation, but which have fallen momentarily out of sync.
The correlation between the two securities refers to the degree that two securities move in relation to one other. More specifically, correlation is a statistical measurement that measures the relationship between the historical performance of two securities. It’s usually expressed as something called a correlation coefficient. This measure falls between -1.0 and +1.0, with negative 1 indicating that two securities move in exactly opposite ways. A correlation coefficient of positive one indicates that the two securities move up and down at exactly the same times under the same conditions.
Pairs Trading Example
In a pairs trade, an investor will look for two securities that have a historically high correlation, but have fallen out of sync. If “stock Alpha” and “stock Beta” have historically risen and fallen in step, they’d have a very high correlation, maybe as high as positive of 0.95. But, for whatever reason, the two stocks have diverged, with Alpha racking up big gains, while Beta languished. That has knocked the short-term correlation coefficient between the two down to paltry 0.50.
This is the most common scenario for a pairs trade. In it, an investor will take a long position on stock Alpha, which has underperformed. At the same time, they’ll short stock Beta, which has outperformed. What they’re doing in a pairs trade is betting that the relationship between the two stocks will return to their historical norm, either by one security falling, the other one rising, or some combination of the two.
Pairs Trading Strategy: Market Neutral
The pairs trade is considered a “market-neutral” strategy. There are many of these strategies, which share a common aim to profit from both rising and falling security prices, while sidestepping the risks of the broader market.
Many hedge funds will employ market-neutral strategies, because they are paid based on their absolute returns. A common market-neutral trade may involve taking a 50% long and a 50% short position in one industry, sector or market. They usually do so to take advantage of pricing discrepancies within those areas. In addition to earning a return, their main goal is often to hedge out as much systematic risk as possible.
For less affluent investors, there are market-neutral mutual funds. Because there are so many market-neutral strategies, and ways to execute them, these funds can vary widely in their returns. Interested investors may want to learn the fund’s particular approach to the strategy before jumping in.
How to Successfully Execute a Pairs Trade
For investors who are ready to incorporate pairs trading into their investment strategy, there are several steps they need to take in order to be successful.
Step One: Decide on Trading Criteria
The first step is to decide what securities to consider for the trade, and can be the most time-consuming in the entire process. This involves researching a vast array of possible investment pairs to find ones that have a historically high correlation coefficient but have since drifted apart. Then investors will want to build and test a model for those securities, using those results to arrive at the best possible buy-and-sell guidelines, as well as how long they intend to stay in a trade.
Step Two: Select Specific Securities
After the investor has settled on a process to select candidates for a pairs trade, it’s time to put that process into action and find securities that currently meet that criteria. Some investors may use manual research, while others prefer mathematical models. Regardless, investors need to think of how they want to use a pairs trade. For investors who want to get in and out of a trade in a matter of hours or days, they’ll need to run their process to find possible trades on a regular basis. But investors whose trades will last for months won’t need to run their research as often.
Step Three: Execute the Trade
Once an investor has confirmed that a trade fits all their criteria, it’s time to execute the trade. With a pairs trade, there are small but important details to consider. For instance, most experienced pairs traders will execute the short side of the trade before making the long side.
Step Four: Manage the Trade
With the trade in place, the investor now has to wait and watch. This means sizing up the activity of the two securities in the trade to see if they’re approaching the criteria that would trigger one of the predetermined buy-and-sell rules. It also means watching the broader market, as well as any news that might have an impact on either security in the trade. Experienced traders will also constantly adjust the trade’s risk/return profile as markets shift and other news emerges.
Managing the trade is as important as setting it up. If a trader has a pairs trade they expect to last a month, but it reaches 50% of its profit objective in the first day after execution, what should they do? They may choose to close out of the trade that day, because the additional return isn’t worth the risk or the opportunity cost. But they also have other options. They might initiate a trailing stop loss level in the two positions as a way of locking in a portion of the profit. The decision isn’t easy, and may involve a host of other considerations.
Step Five: Close the Trade
The final step is to close the trade. But even this can come with questions and challenges, especially with trades that haven’t worked out, and whose predetermined durations are coming to an end. But it can also be the case with trades that have succeeded and are nearing their time limit. The urge to give a trade more time to turn around—or to do just a little better—has the potential to be the undoing of an otherwise successful trader.
That’s why experienced pairs traders often stress discipline as being as important as research, close monitoring and clear rules when it comes to earning consistent profits with the strategy.
Pairs trading is a trading strategy that involves the simultaneous purchase and sale of securities in anticipation of a price trend. The idea is that the two securities typically have shown a high historical correlation, but have fallen momentarily out of sync. The investor making the pairs trade is betting that the two stocks will return to their historical norm.
Investors looking for a hands-on trading experience might consider opening an opening an online brokerage account. SoFi Invest® offers an active investing solution that allows you to choose stocks, ETFs, crypto, and more, and manage your account from the convenient mobile app.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected] Please read the prospectus carefully prior to investing. Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.