Pairs trading or, more officially, statistical arbitrage or spread trading, allows traders to invest in the spread between two stocks that are related but different. This helps develop market-neutral strategies. You don’t have to know if the market is going up or down today, just what will happen between the two correlated stocks. This reduces risk.
Spread trading is a concept more common with options, where it is easy to buy and sell different options on the same underlying stock or other security. It’s not as common or obvious with different actions.
However, many actions are correlated. Some are positively correlated. That means that what happens to one company is likely to affect the other company in the same way.
For example, shares of Ford are positively correlated with shares of a company that supplies it with auto parts. When Ford sells a lot of cars, the parts company gets a lot of business. When Ford’s sales are slow, so are the parts company’s sales.
A negative correlation means that what is good for one company is bad for another and vice versa. For example, if all Wendy’s customers leave Wendy’s and buy hamburgers at McDonald’s, that’s bad for Wendy’s but good for McDonald’s.
However, the pairs trader must be careful. Sometimes trends affect entire industries, including industry leaders and laggards.
For example, both companies have benefited from the decades-long trend for Americans to eat far more meals at fast-food restaurants. If too many Americans suddenly decided to stay home and cook, that would have a negative impact on both companies.
What is important to realize is that you are not trying to predict the price movement of either stock. You are negotiating with the price differential between them. These trades tend to be very limited in range.
Two similar, often competing stocks often trade within a particular spread range. When they come out of it, it’s usually temporary. The pairs trader takes a position that will soon return to convergence.
With this type of spread trading, you will find two correlated stocks, usually large companies listed on the New York Stock Exchange, trading at an abnormal spread. Typically, you will buy one of the stocks and short the other and thus make a profit when their prices return to the historical line with each other. You are covered. Yes, one side of the trade makes money while the other loses, but if you have planned well and the trade goes well, your position as a whole is profitable.
And with this type of arbitrage, there is less volatility, because the two trades tend to largely cancel each other out, leaving only your net profit.
Because you will be selling shares short, you must have a margin account. Also, this strategy is not allowed in tax-deferred accounts, such as IRAs and Roth IRAs.
And the trader must realize that if the two stocks are subject to market drift, they may never return to the old convergence. Perhaps something has happened to realign their respective positions in their sector.
For example, if all soda drinkers suddenly ditched Pepsi products and drank only KO products, that would change the relative positions of the two companies.
In general, however, well-planned and executed pairs trading is less risky than betting on the direction of the entire market or one particular stock.
