Equity Valuation and Portfolio Management

PAIRS TRADING

One of the earliest, and still most commonly used, forms of statistical arbitrage is in pairs trading. Pairs trading has been around since listed exchanges have opened, and it serves as the basis for most trading strategies. Pairs trading is a strategy that simultaneously buys one security and sells another to profit from the “spread” between the two.¹ The investor hopes that the asset he or she bought goes up relative to the asset that was sold short. What matters is the relative movement of prices, not the absolute movement of prices: One can have both prices go down as long as the one that is shorted goes down faster than the one you are long. Properly constructed, this can be a “market neutral” strategy. A market neutral strategy is when the profitability of a strategy is independent of the level of prices and only dependent on the relative price movements of the assets.

A trading opportunity usually arises as a result of some event that disrupts the normal relationship between the prices of the assets. For example, an announced merger or acquisition can dramatically alter the price of a security. In this case, a “merger arb” strategy can be used to speculate on the likelihood of the announced transaction closing. Another example is when there is a macroeconomic event that may affect one security's price more than another. This can happen with “global macro” strategies that invest on the basis of political changes or changes in global factors. Generally speaking, ...