Pairs trade: Difference between revisions
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The '''pairs trade''' was |
The '''pairs trade''' was developed in the late 1980's by quantitative analysts. They found that certain securities, often competitors in the same sector, were correlated in their day-to-day price movements. When the correlation broke down, i.e. one stock traded up while the other traded down, they would sell the outperforming stock and buy the underperforming one, betting that the "spread" between the two would eventually converge. |
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Revision as of 00:10, 22 September 2005
The pairs trade was developed in the late 1980's by quantitative analysts. They found that certain securities, often competitors in the same sector, were correlated in their day-to-day price movements. When the correlation broke down, i.e. one stock traded up while the other traded down, they would sell the outperforming stock and buy the underperforming one, betting that the "spread" between the two would eventually converge.
Some real-life examples of potentially correlated pairs:
Coke (KO) and Pepsi (PEP)
Wal-Mart (WMT) and Target (TGT)
Dell (DELL) and Hewlett-Packard (HPQ)
Ford (F) and General Motors (GM)
The beauty of the pairs trade is that it helps to hedge sector- and market-risk. For example, if the market as a whole crashes and your two stocks plummet along with it, you should experience a gain on the short position and a negating loss on the long position, leaving your profit close to zero in spite of the large move. In a pairs trade, you are not making a bet on the direction of the stocks in absolute terms, but on the direction of the stocks relative to each other.
DISCLAIMER: This article is intended for educational purposes only. The author of this article assumes no responsibility for any gains or losses associated with trades executed as a result (directly or indirectly) of reading this article.