What is pairs trading and how does it work?

Pairs trading is a market-neutral strategy that involves matching a long position with a short position in two highly correlated assets. Traders identify a pair of securities, such as two stocks in the same industry, that historically move in tandem. When the price relationship between these assets diverges beyond a statistical norm, the trader bets that the spread will revert to its historical mean. To execute this strategy, a trader buys the underperforming asset and sells the outperforming asset short. If the spread narrows, the trader closes both positions to capture the profit. For example, if Stock A and Stock B typically trade at a ratio of 1:1, a divergence where Stock A rises while Stock B falls creates a trading opportunity. The trader shorts Stock A and buys Stock B, expecting the price gap to close. This strategy relies on statistical analysis and mean reversion rather than directional market trends. Success depends on the correlation between the two assets remaining stable over time. Trading involves significant risk, including the possibility that the correlation breaks down permanently or that the spread widens further before reverting. Proper risk management and position sizing are essential to mitigate potential losses from unexpected market volatility.