Definition
Pairs trading is the simplest form of statistical arbitrage. It identifies two historically correlated securities, measures their price spread, and trades when the spread deviates significantly from its mean. The strategy profits from spread reversion regardless of market direction. Cointegration testing (not just correlation) determines suitable pairs.
lightbulb Example
Coca-Cola and PepsiCo have a cointegrated price relationship. When the spread widens to +2 standard deviations (Coke relatively expensive), the strategy shorts Coke and buys Pepsi. When the spread reverts, both positions are closed for a profit.
verified_user Key Points
- Market-neutral—profits from spread reversion
- Cointegration is better than correlation for pair selection
- Works regardless of market direction
- Risk: structural break in the relationship