Why Trade Pairs?

The strategy known as pairs trading has the potential to increase returns without being dependent on the direction of the market.

With this strategy there are scarce opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity. While it is commonly agreed that individual stock prices are difficult to forecast, there is evidence suggesting that it may be possible to forecast the price—the spread series—of certain stock portfolios.

The main advantages of pair trading are as follows:

(i) The Pair Trade helps to reduce sector- and market-risk. For example, if the whole market crashes, and the two securities fall along with it, the trade should result in a gain on the short position and a negating loss on the long position, leaving the profit close to zero in spite of the large move.

(ii) Pair Trading is a mean-reverting, non-directional strategy, betting that the prices will eventually revert to their historical trends. Back test results show that this is the case among specified sectors.

(iii) Pair Trading is a substantially self-funding strategy, since the short sale proceeds may be used to offset the long position.

(iv) Pair Trading provides investors the ability to trade across various asset classes and global markets (not only restricted to stocks). The ability to go long and short in different securities reduces cross country risk and enhances the diversification of a portfolio.