Pair Trading

Pair trading is a market-neutral quantitative strategy that exploits the relative price relationship between two correlated assets.

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Core Idea

Two assets that historically move together tend to revert to a stable relationship.

When the relationship deviates:

buy the underperformer and short the overperformer

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Setup

Choose two correlated assets:

• Stock A
• Stock B

Define a relationship:

• price ratio
• spread
• statistical model (e.g. regression residual)

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Trade Logic

When A becomes expensive relative to B:

• Short A
• Long B

When A becomes cheap relative to B:

• Long A
• Short B

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Goal

Profit from:

mean reversion of the price relationship, not direction of the market

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Market Neutrality

Pair trading aims to reduce exposure to overall market movement:

• One long position
• One short position

$\text{Net Exposure} \approx 0$

So:

returns depend on relative mispricing, not market direction

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Spread Concept

The key variable is the spread:

$\text{Spread} = P_A - \beta P_B$

Where:

• ( $\beta$ ) adjusts for scale or hedge ratio

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Entry / Exit Signal

• Enter trade when spread deviates significantly from mean
• Exit when spread reverts back

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Why it works

Pair trading relies on:

• statistical correlation
• temporary mispricing
• mean reversion behavior

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Risk Considerations

• correlation can break down
• structural regime changes
• execution + transaction costs
• model mis-specification

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Connection to Portfolio Theory

Pair trading is a special case of portfolio optimization:

• Two-asset hedge portfolio
• Minimizes market exposure
• Optimizes relative return vs risk

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One-line Summary

Pair trading is a market-neutral strategy that profits by betting on the convergence of the price relationship between two historically correlated assets.