Pairs Trading Strategy Guide

Pairs trading is a strategy which involves taking opposing positions in two separate, highly correlated instruments. If you are interested in learning about what a pairs trade is, how to create a pairs trading strategy and more, read on!

The information in this article is provided for educational purposes only and does not constitute financial advice. Consult a financial advisor before making investment decisions.

What Is Pairs Trading?

Pairs trading is a strategy in which traders look to profit from a temporary divergence in the prices of two positively correlated assets. The strategy is based on the assumption that, if two assets have had a positive correlation in the past, they will continue to do so in the future.

Firstly, a trader must find two different assets which have a demonstrably high positive correlation. Once identified, the trader waits for a divergence in the asset prices, at which point they might attempt to profit by employing a pairs trading strategy.

The strategy involves initiating a position in both assets: a long position in the asset which is underperforming and a short position in the one which is overperforming.

The assumption behind this is that, following the divergence, the prices of the two assets will move back towards each other as they continue their historic correlation. If that happens, it will hopefully result in a profit in one or both of the positions.

Pairs Trade Example

To help illustrate our definition, let’s take a look at a hypothetical example of a pairs trade. Imagine that the share prices of Company A and Company B have a high, positive correlation.

However, despite this correlation, the prices of the two stocks begin to move in opposite directions: Company A’s share price rises whilst Company B’s share price falls.

A pairs traders, having identified this divergence in price, assumes that the divergence will be temporary and the two stocks will eventually resume their historic correlation. Consequently, the trader enters two positions: a short trade on Company A and a long trade on Company B. 

The logic is that, assuming the companies’ share prices eventually converge, one or both of these positions should turn a profit. For example: 

• If Company A’s share price falls back towards Company B, the short trade will profit. 
• If Company B’s share price rises and catches up with Company A, the long trade should profit. 
• If Company A’s share price falls and Company B’s share price rises, both trades should profit.

This illustrates the concept behind the strategy, but it should not be taken as a guarantee of profit.

How to Create a Pairs Trading Strategy

Now we have a better understanding of what a pairs trade is, let’s take a look at how a trader might go about creating a pairs trading strategy.  

Find a Pair

The first step in creating a stock pair trading strategy would be to identify a pair of highly, positively correlated stocks. But how does one do that? 

A good place to start is by looking at companies which operate in the same industry.  

For example, it would be logical to expect the share prices of Coca-Cola and PepsiCo to be positively correlated. You might also make the same assumption about tech giants Apple and Microsoft.

Demonstrate a Correlation

Although you might expect two stocks to have a positive correlation, it may not be the case in reality. Consequently, the next step when pair trading stocks would be to actually confirm the presence of a strong, positive correlation.

It is possible to calculate the correlation coefficient yourself. However, there are also various tools you can use to help with the calculation, such as the Admiral Markets Correlation Matrix.

In the example below, we have used this tool to examine the correlations between four oil and gas majors listed in the US over the last 1,000 days.

The Correlation Matrix displays numbers between –100 and 100. A score of –100 implies a perfectly negative correlation, whereas a score of 100 would indicate a perfectly positive correlation. A score of zero implies that there is absolutely no correlation whatsoever.

It’s not surprising to learn that, over the long-term, the oil and gas majors above all have a strong positive correlation with each other. Let’s take a look at the strongest of these correlations, between Chevron and ConocoPhillips.

Wait For a Divergence

Once a strong, positive correlation has been established, a trader must wait for a deviation from this correlation before acting.

How can traders establish that a deviation is taking place? There are a number of ways in which traders might choose to do this.

One way would be to monitor the short-term correlation coefficient of the two stocks using the Correlation Matrix. Once the coefficient drops below a certain threshold, the trader might choose to act.

Another might be to analyse the historical ratio of the two share prices. The chart below shows the weekly price ratio between ConocoPhillips and Chevron over the last five years, calculated by dividing ConocoPhillips’s share price by that of Chevron.

An increasing price ratio indicates that ConocoPhillips is outperforming Chevron, whilst a decreasing ratio indicates the opposite. 

We can see that for the majority of the time above, the price ratio remains within a range of 1.2 and 2. The horizontal line demonstrates the average price ratio over the period, which is 1.6.

A pairs trading strategy might dictate that, once the price ratio breaks out of a predetermined range, the trader initiates their positions in the market.

For example, in the case of ConocoPhillips/Chevron above, when the price ratio breaks above 2, a trader might choose to:

• Short ConocoPhillips  
• Buy Chevron 

On the other hand, if the ratio breaks below 1.2, a trader might:

• Buy ConocoPhillips 
• Short Chevron 

Please note these are illustrative examples only and do not constitute a comprehensive trading strategy or recommended assets. 

Final Thoughts

A pairs trading strategy can be useful for traders to understand, as it can be implemented regardless of market conditions.

However, the strategy is based on the assumption that if two assets have been positively correlated in the past, they will continue to be so in the future. Of course, this isn’t necessarily true.

Just because prices have behaved a certain way historically, it doesn’t mean they are guaranteed to continue behaving that way in the future. Past performance is not a reliable indicator of future results.

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