Most stock market investors buy shares and want the market to rise. A smaller group of investors take short positions and want the market to fall. Pair traders don’t mind what the market does - simply seeking to profit from the relative performance of two related stocks. Used by institutions, hedge funds and investment banks for over three decades, it remains surprisingly under-utilized by the average investor.
The pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. The pair trading was first pioneered by Gerry Bamberger and later led by Nunzio Tartaglia’s quantitative group at Morgan Stanley in the 1980s.
When the correlation between the two stocks temporarily weaken (i.e. one stock moves up while the other moves down), the pair trade would be to short the outperforming stock and to take a long position on the under performing stock, betting that the "spread" between the two would eventually converge (or come together).
The divergence within a pair can be caused by macroeconomic factors such as changes in interest rates, government spending, unemployment rate or micro-economic factors such as changes in supply/demand forecasts, production reports, revenue margins and management changes.
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