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Pairs Trading
"A statistical arbitrage strategy that shorts the outperforming asset and buys the underperforming asset in a correlated pair, betting on spread convergence."
In-Depth Definition
Pairs Trading is a market-neutral strategy developed by Morgan Stanley quants in the 1980s. It exploits temporary deviations in the historical relationship between two highly correlated or cointegrated assets (e.g., TotalEnergies and BP, Gold vs Silver, EUR/USD vs GBP/USD). When the spread between two assets deviates significantly from its historical mean, one sells short the outperforming asset (relatively overvalued) and buys the underperforming one (relatively undervalued), betting the spread will narrow. The position is 'market-neutral': theoretically immunized against directional market moves. Key steps: 1) identify cointegrated pairs via statistical tests, 2) calculate the spread Z-score to define entry/exit thresholds, 3) manage position sizing for dollar-neutral legs.
StarQuant Insight
StarQuant automatically identifies the best trading pairs via cointegration tests on rolling history, and dynamically calibrates entry/exit parameters based on Z-score and current spread volatility.
Pro Tip
The main error in pairs trading is not verifying that cointegration is still valid before entry. A previously cointegrated pair may cease to be so after a fundamental change (merger, sector disruption). Regularly re-evaluate your pair universe.