What Is Pairs Trading?
Pairs trading is a statistical arbitrage strategy: identify two historically correlated assets (e.g. KO and PEP, or two ETFs tracking the same sector), and when the spread between them deviates from its mean, go long the underperformer and short the outperformer.
The bet isn't on market direction — it's on the spread reverting. If the market crashes, both legs fall and the strategy is hedged. The risk is that the historical correlation breaks down due to a fundamental change in one of the assets, leaving you with a one-sided exposure.
Pairs trading was the original 'quant' strategy in the 1980s and made fortunes for early adopters. Today, the obvious pairs are arbitraged constantly by HFT firms. Retail traders can still find slower-moving pairs (1-2 day mean reversion) but the edge has thinned dramatically over four decades.
Related terms
- Mean Reversion — Strategy betting that price will return toward its average after extreme moves.
- Correlation
- Arbitrage
- Strategy