pairs trading
A market-neutral strategy buying an underperforming security and short-selling a related outperforming one, betting the historical relationship will revert.
Example
“The pairs trade went long Coke and short Pepsi when their prices diverged abnormally — expecting reversion to historical spread.”
Memory Tip
PAIRS TRADING = long one, short the other. Bet the relationship between two stocks reverts to normal.
Why It Matters
Understanding pairs trading helps investors recognize that not all profitable strategies require betting on overall market direction. This approach appeals to individuals seeking market-neutral returns that aim to profit regardless of whether stocks rise or fall, making it relevant for diversified portfolio construction.
Common Misconception
Many people mistakenly believe pairs trading eliminates all risk because it is market-neutral. However, the strategy still carries significant risks if the historical relationship between the two securities fails to revert, potentially resulting in losses on both positions simultaneously.
In Practice
Suppose two airline stocks historically trade in lockstep, with Stock A trading at 50 dollars and Stock B at 55 dollars. A pairs trader notices Stock A has fallen to 45 dollars while Stock B remains at 55 dollars, breaking their pattern. The trader buys Stock A at 45 dollars and short-sells Stock B at 55 dollars, betting they will realign when Stock A recovers to 50 dollars and Stock B declines to 50 dollars, capturing a profit on both legs.
Etymology
PAIRS (two related securities) TRADING. TRADING matched PAIRS of related securities against each other.
Common Misspellings
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Related Terms
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See Also
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