Written by Cory Mitchell. Updated by TraderHQ Staff.
Traders have hundreds of technical tools and price action strategies to help them take advantage of price trends and ranging markets, but pairs trading is something completely different. Pairs trading uses correlations and divergences between two stocks in an attempt to capture a profit. While it isn’t riskless, by understanding how pairs trading works, how you control risk and how you manage profits, it’s a great tool to add to your trading arsenal because the strategy isn’t dependent on market direction.
Pairs Trading 101
Pairs trading is when a simultaneous long position is taken in one stock while a short position is taken in another.
The stocks must be highly correlated, meaning most of the time they move in the same direction. Typically, this is seen in the stocks of companies that are very similar, such as Coca-Cola (KO) and PepsiCo (PEP), or Ford (F) and General Motors (GM).
Since the stocks of these companies move in a similar fashion due to their similar business—we always must check to make sure they are moving in a similar fashion—when their stocks diverge it presents a trading opportunity. The strategy is to buy the stock that is underperforming and short-sell the one that is outperforming the other. Doing this safely requires some research and risk controls.
For a deeper dive into the mechanics and history of this market-neutral strategy, see Investopedia’s comprehensive guide to pairs trading.
Identifying Correlated Pairs
The first step is finding two stocks that historically move together. Look for:
- Companies in the same industry with similar market caps
- Stocks with a correlation coefficient above 0.80
- Historical patterns of mean reversion when prices diverge
Use charting software to overlay price charts and visually confirm the correlation. When the spread between the two stocks widens beyond historical norms, a trading opportunity may exist.
Executing the Trade
When a divergence occurs:
- Go long the underperforming stock (the one that has fallen more or risen less)
- Go short the outperforming stock (the one that has risen more or fallen less)
- Size positions so that dollar amounts are roughly equal on each side
The goal is market neutrality—if the overall market moves up or down, your long and short positions should roughly offset each other. Your profit comes from the convergence of the pair back to their normal relationship.
Risk Management
Even with market-neutral strategies, risks exist:
- Divergence can continue – The spread may widen further before converging
- Correlation breakdown – Fundamental changes can permanently alter the relationship
- Execution risk – Slippage on entry and exit affects profitability
Set stop-losses based on the spread widening beyond acceptable levels, not on individual stock prices. Many traders risk 1-2% of their account per pairs trade.
The Bottom Line
Pairs trading offers a way to profit regardless of market direction by exploiting temporary mispricings between correlated securities. Success requires careful pair selection, proper position sizing, and disciplined risk management. While not risk-free, pairs trading can provide diversification benefits and reduce overall portfolio volatility when executed correctly.
Frequently Asked Questions
How do I calculate the correlation between two stocks?
Use a spreadsheet or trading platform to calculate the Pearson correlation coefficient using historical price data. Most platforms offer this as a built-in feature. Look for correlations above 0.80 over a 6-12 month period, and verify the correlation remains stable across different time periods.
What causes pairs to diverge and then converge again?
Short-term divergences often result from temporary factors: earnings surprises, analyst upgrades/downgrades, sector rotation, or news affecting one company more than the other. Because the underlying business fundamentals remain similar, prices typically revert to their historical relationship as the temporary factor fades.
Can pairs trading be automated?
Yes, pairs trading is well-suited for algorithmic execution. Many traders use quantitative models to monitor spreads, calculate z-scores, and automatically enter/exit positions when divergence reaches predetermined thresholds. However, even automated systems require regular monitoring for correlation breakdowns.