👯 Trading strategy

Pairs Trading: How It Works, Rules & Example

Pairs trading looks for two closely related assets whose prices usually move together, then trades the gap when it stretches unusually wide. It buys the relative underperformer and shorts the outperformer, betting the gap will narrow.

AdvancedMedium risk⏳ Days to weeksBest for: Advanced traders comfortable with statistics, short selling and managing hedged positions.

How it works

Find two assets with a strong historical relationship, such as two companies in the same industry.
Calculate the price ratio or spread between them over time.
Measure how far the current spread sits from its average, often in standard deviations.
When the spread is unusually wide, buy the cheaper asset and short the richer one in balanced amounts.
Close both legs when the spread returns toward its average or a stop is hit.

The rules

EntryEnter when the spread moves about two standard deviations away from its average.

ExitExit when the spread returns near its average or hits a predefined stop, such as three standard deviations.

RiskUse balanced position sizes, a time limit and a stop, because relationships can break permanently.

👍 Pros

Less dependent on overall market direction.
Based on measurable statistical relationships.
Can work in flat or choppy markets.

👎 Cons

Relationships can break due to company-specific news.
Requires short selling, which has its own costs and risks.
More complex to manage two positions at once.
Statistical patterns from the past may not continue.

Worked example

Example: Two hypothetical companies usually trade at a price ratio near 1.50. The ratio jumps to 1.70, about two standard deviations above normal. You short $5,000 of the pricier stock and buy $5,000 of the cheaper one. If the ratio returns to 1.55, both legs together could produce a gain, while a broad market drop affects both sides similarly.

See it on a chart

Demo of the Bollinger Bands on a simulated price path.

Common mistakes

Pairing assets that only look related but have no real economic link.
Using unequal position sizes that leave hidden market exposure.
Holding a losing spread indefinitely hoping it will return.

Tools for this strategy

📐 Position Size Calculator 📊 Percent Change & Recovery Calculator ⚖️ Risk/Reward Ratio Calculator

Indicators it uses

🎯 Bollinger Bands 〰️ Simple Moving Average

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FAQ

What is market-neutral?

It means the strategy aims to profit from relative moves rather than the market's overall direction.

Do I need to short sell?

Typically yes, though some traders use other instruments to create the same exposure.

What is cointegration?

It is a statistical property suggesting two price series tend to move back together over time.

Educational only – not financial advice. This page explains ideas and reports the news. It is not a recommendation to buy, sell or hold anything. Markets go up and down and you can lose money. Do your own research and consider talking to a licensed adviser.

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