How Pair Trading Works

We recommend reading What is Pair Trading before the rest of this article.

 

We think of the combined stocks as a “unit”.  We can either be Long or Short the unit or the pair.

If the pair we chose was XOM vs XLE and we always kept XOM as the first symbol and XLE as the second symbol, then we could combine them as XOM/XLE (ratio) or XOM-XLE (differential).  We would say we are “Long the Pair” if we were long XOM and short XLE.  Conversely, we would be “Short the Pair” if we were short the first symbol (XOM) and long the second symbol (XLE).

There is no correct way on how to structure the pair, but rather it is trader preference.  The key is to choose what works for your trading and data platforms, as well as the time frames you are trading in.
For someone who wants to hold overnight, it could look different than for the day trader.

That being said, we have our preferred method and style of setting up and naming a pair. More...

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What is Pair Trading?

The concept of pairs trading, or relationship-based trading, comes from Morgan Stanley, where a group of researchers first developed the strategy in the 1980s. Simply put, pairs trading requires you to match a long position against a short position on a pair of stocks that are highly cointegrated.  There may also be high correlation as they track together through market fluctuations. Once you find the some great pairs to trade, it can be a very effective trading strategy, insulating you from the market gaps, reversals and overall volatility, but tracking, executing and managing the combinations takes knowledge, time, skill, historical and current data.

Benefits of pair trading

Relationship-based trading helps to identify probability and predictability.  Volatility increases your chances to take trades over and over again increasing production on a pair or portfolio of pairs.  You may be able to identify the leading stock and the stock that lags.  This will assist...

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