A pair trade is a trading strategy that involves matching long and short positions in two highly-correlated securities. Essentially, you make opposite bets on different but related securities in the hopes that their opposing price movements yield a profit.
Pair trading is a strategy wherein a trade bets that two securities will diverge or converge in price. (Correlation measures how closely two assets move together. The higher the correlation, the more likely securities will move in the same direction under the same conditions.)
You can trade pairs in stocks, bonds and commodities or even between asset classes. Most of the time, these securities are in the same industry or sector, though not always.
Specifically, pair traders seek highly correlated assets they believe have strayed from their “true” price. They take a long position in the asset they believe is undervalued and short the asset they think is overvalued. Then, when the securities (hopefully) return to their “true” price, they snag a profit.
For instance, consider Coke and Pepsi. On paper stocks are nearly identical – they’re both mature companies that sell similar products. In theory, they should share a high correlation.
Now, let’s say that Coke stock drops 25%, while Pepsi stock rises 25%. As a pair trader, you might approach this in two ways:
If you make the right call, you stand to profit from both stock movements. But even if you’re wrong about one stock, you can still make a profit – or at least avoid a loss.
Pair trading is less a specific strategy and more a type of trade. Essentially, you’re buying one asset and shorting another while hoping to profit off both transactions. As such, there’s no “right” way to approach pair trading.
For instance, some investors take a quantitative approach, using numbers, historical charts and statistical analysis to determine the “best” pairs. Others rely on sophisticated ideas about business strategies, market cycles and competitive advantage to make pair trades. (For example, buying GM and shorting Ford because you think GM has a better business model this year.)
Pair trading is widely seen as a market-neutral hedging strategy that allows you to “straddle” a trade while profiting against any move the market makes. Unfortunately, while it sounds easy on paper, in practice, it takes a skilled trader with experience, time and money to pull off.
But you don’t have to be an expert to profit on pair trades. In fact, many of Q.ai’s Investment Kits take advantage of AI-backed pair trades, including our Gas Spike, Outperformance, Bond Spread and Tech Rally Kits.
All you have to do is choose your preferred Kit, risk tolerance and investment size – we’ll take care of the rest.
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