Pairs Trading
AdvancedDaily to intradayAlgorithmic
Strategy Overview
Market-neutral strategy trading the spread between correlated securities.
How It Works
Pairs trading is a market-neutral strategy that profits from the convergence of two correlated securities that have temporarily diverged. By going long the underperformer and short the outperformer, traders profit regardless of market direction. This strategy requires sophisticated analysis to identify suitable pairs, calculate hedge ratios, and determine entry/exit points based on statistical measures like z-scores. It's popular among hedge funds and prop traders for its consistent returns and low market risk.
Setup Rules
- 1Find highly correlated pairs (>0.8)
- 2Test for cointegration
- 3Calculate historical spread
- 4Determine z-score thresholds
- 5Set position size ratios
Entry Rules
- Enter when z-score exceeds ±2
- Long underperformer, short outperformer
- Use proper hedge ratio
- Confirm divergence isn't fundamental
Exit Rules
- Close when spread returns to mean
- Or at opposite z-score threshold
- Stop if spread exceeds 3 std dev
- Time stop after X days
Risk Management
- Dollar neutral positions
- Beta neutral preferred
- Stop at maximum divergence
- Diversify across multiple pairs
Advantages & Disadvantages
Advantages
- • Market neutral returns
- • Lower risk than directional
- • Consistent profits possible
- • Works in all market conditions
Disadvantages
- • Requires sophisticated analysis
- • Correlation can break down
- • Needs margin for shorting
- • High commission costs
Best Market Conditions
Any market condition with normal correlation