What is Pair Trading?
Pair trading is the strategy of trading two securities simultaneously, one long and one short. These trades combined constitute a pair.
Pair Trading was developed as a strategy that seeks to generate significant and consistent returns while controlling risk by maintaining a low correlation to broader market averages.
Pair Trading is a market neutral strategy is meant to profit regardless of whether equities rise or fall.
A profit or loss on a pair trade depends on whether the spread between paired positions widens or narrows.
Pair Trading Strategy
The strategy behind pair trading is to find similar assets with dissimilar valuations. This is done by analyzing companies that are relatively similar (same industry or subsector) and correlated but are valued differently by the market. Investors would then buy the cheap asset while selling the rich asset playing for a convergence in value.
The strategy of pair trading is mean reverting. Where a pair of two highly correlated assets historically traded in a tight range but now trades one or more standard deviations away from historical means. A trader would look for a pair to revert to the mean.
Popular valuation metrics to analyze and compare companies are
- P/E
- PEG
- Dividend Yield
- Price / Book
- EV / EBIT
- EV / EBITDA
- EV / Sales
Other factors when selecting pairs
- Volatility
- Volume
- Sector