We are independent & ad-supported. We may earn a commission for purchases made through our links.
Advertiser Disclosure
Our website is an independent, advertising-supported platform. We provide our content free of charge to our readers, and to keep it that way, we rely on revenue generated through advertisements and affiliate partnerships. This means that when you click on certain links on our site and make a purchase, we may earn a commission. Learn more.
How We Make Money
We sustain our operations through affiliate commissions and advertising. If you click on an affiliate link and make a purchase, we may receive a commission from the merchant at no additional cost to you. We also display advertisements on our website, which help generate revenue to support our work and keep our content free for readers. Our editorial team operates independently of our advertising and affiliate partnerships to ensure that our content remains unbiased and focused on providing you with the best information and recommendations based on thorough research and honest evaluations. To remain transparent, we’ve provided a list of our current affiliate partners here.
Finance

Our Promise to you

Founded in 2002, our company has been a trusted resource for readers seeking informative and engaging content. Our dedication to quality remains unwavering—and will never change. We follow a strict editorial policy, ensuring that our content is authored by highly qualified professionals and edited by subject matter experts. This guarantees that everything we publish is objective, accurate, and trustworthy.

Over the years, we've refined our approach to cover a wide range of topics, providing readers with reliable and practical advice to enhance their knowledge and skills. That's why millions of readers turn to us each year. Join us in celebrating the joy of learning, guided by standards you can trust.

What is Pairs Trading?

John Lister
By
Updated: May 17, 2024
Views: 4,537
Share

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.

Share
WiseGeek is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
John Lister
By John Lister
John Lister, an experienced freelance writer, excels in crafting compelling copy, web content, articles, and more. With a relevant degree, John brings a keen eye for detail, a strong understanding of content strategy, and an ability to adapt to different writing styles and formats to ensure that his work meets the highest standards.

Editors' Picks

Discussion Comments
John Lister
John Lister
John Lister, an experienced freelance writer, excels in crafting compelling copy, web content, articles, and more. With...
Learn more
Share
https://www.wisegeek.net/what-is-pairs-trading.htm
Copy this link
WiseGeek, in your inbox

Our latest articles, guides, and more, delivered daily.

WiseGeek, in your inbox

Our latest articles, guides, and more, delivered daily.