Pairs trading is an investment strategy based around the idea that stocks in certain companies tend to be closely linked. This is most common with two companies in the same industry. When the two stocks move in different directions, a pairs trader will buy and sell based on the assumption they’ll eventually move back together.
Investors carry out pairs trading on a wide variety of stocks. The goal is usually to find two stocks which are affected by a very similar range of factors. One example would be McDonald's and Burger King. Many factors which affect McDonald’s stock price, such as people having shorter lunch hours and buying more fast food, or a health scare over hamburgers, will affect Burger King in the same way.
An investor will normally carry out pairs trading when the relationship between the two stocks temporarily breaks down. For example, McDonald's stocks may suddenly become much more highly valued in comparison to Burger King. The investor will sell McDonald's stock and buy Burger King. This is because they believe that whatever caused the change in prices is likely a temporary factor and, in the long run, the effect of the common factors will re-establish the relationship between the stocks. That would likely mean McDonald's stock drops, Burger King stock rises, or both.
It’s important to realize that the stocks involved in pairs trading do not have to be at a similar price. In some cases, one stock can consistently be much higher than the other. What matters is that the relative position between the two is usually the same. This is because they tend to rise or fall at the same time in similar proportions.
A more complicated version of pairs trading is to short the stock they feel will go on to perform the worst of the two. Shorting involves borrowing a stock from another trader, selling it, then buying back the stock to give it back to the original trader at an agreed later date. The idea is to do this with a stock you believe is going to fall in price. If this does happen, you will take more money from selling the borrowed stock than you spend buying the stock to give back.
In this form of pairs trading, the investor does not have to wait until the two stocks begin to drift apart. Instead they short one stock and take a long position on the other, meaning they buy it with their own funds. This tactic makes it possible to make money even if the entire market falls. That’s because the investor’s gamble is based around the relationship between the two stocks, not their actual prices. Pairs trading in this fashion means the investor makes money when they correctly predict which stock will perform better in comparison to the other.
There are some drawbacks to this form of pairs trading. In most cases investors can’t simply short a stock through the usual trading markets. Instead they have to use a financial instrument such as a contract for difference or spread betting. This increases the complexity of the deal. Pairs trading also means you have to pay commission and other trading costs twice because there are two different stocks, which can eat into profits.