Glossary
Pairs Trading
A market-neutral strategy that trades two historically linked assets when their price ratio diverges from its mean.
Pairs trading identifies two cointegrated securities and takes a long position in the underperformer and a short position in the outperformer when their spread widens. The trade profits when the spread reverts to its historical average.
Key Points
- Cointegration is more important than simple correlation.
- The z-score is commonly used to measure spread deviation.
- Pairs trading is vulnerable to regime changes that break the historical relationship.