It’s all relative (value): The art and science of pairs trading

Open full sized image

When one goes up, the other one goes … ?

© Tero Vesalainen—iStock/Getty Images

Imagine two businesses operating in the same market, running the same strategies, and offering similar products. Although they’re competing with each other, their earnings and stock performance tend to move in sync. Both are highly correlated; it’s almost like they’re tethered together.

When one stock moves up or down, the other tends to follow suit. One stock may significantly jump ahead or fall behind the other (i.e., fall out of correlation), but such anomalies have, historically, turned out to be short-term blips. In a matter of time, their movements end up converging.

This high degree of correlation, suggesting that one stock will always (eventually) catch up with the other, is at the heart of a strategy called pairs trading.

The assumption is that highly correlated stock pairs will continue to move in a comparable, measurable, and hence predictable manner. And if their prices diverge, it can present a profit as prices converge back toward their correlated state.

But sometimes, two historically correlated stocks diverge and stay that way, due, perhaps, to a permanent fundamental change in one of the two companies. There’s a pairs trading strategy for that case as well.

An important note for this discussion: Selling stocks short requires a margin account, which typically has special rules and capital requirements.

A pairs trade is a market-neutral trading strategy in which you buy (take a long position in) a stock or other security and sell (take a short position in) another security. The typical goal of a pairs trading strategy is to find a pair that has fallen out of its historical correlation and seek to profit as the spread between them closes back toward historical correlation levels. It’s a type of relative-value arbitrage.

And what exactly is a market-neutral strategy? It’s one with no directional bias—it doesn’t matter if the prices of both securities in a pair go up or down. In the case of pairs trading, all that matters is whether their relative prices converge back toward their historical spread levels.

And if they don’t converge? That’s the risk of arbitrage-based pairs trading. (But it’s also an opportunity for anyone who’s been watching the fundamentals and is expecting a divergence.)

Imagine two stocks—ABC and XYZ—that usually move together by a comparable amount. So, if one stock gains, say 2%, the other stock also rises around 2%.

Then suddenly, an unusual price movement occurs: ABC jumps 10%, while XYZ rises only 5%.

The trader wasn’t betting on both stocks moving in any given direction, up or down. All the trader cared about was that the stocks’ prices should revert to their usual price relationship—not jumping too far ahead or behind relative to the other.

The Cola Wars rivalry between Coca-Cola (KO) and PepsiCo (PEP) is a classic example of two similar companies that are locked in a perpetual battle over the same customers. Every now and then, one gets ahead of the other. But generally, their movements tend to shadow one another.

See the bottom pane in figure 1, which shows the Correlation Coefficient indicator from StockCharts.com:

Open full sized image

Figure 1: CARBONATED RIVALRY. Shares of Coca-Cola (KO—blue line) and PepsiCo (PEP—black line) tend to move in the same general direction, but with periods of relative divergence and convergence, as evidenced by the Correlation Coefficient indicator from StockCharts.com (bottom pane).

Image source: StockCharts.com.

Now, look at a price chart (the top half of figure 1) to see how these correlations come into play. Do you see how the pairs generally move together over time? When prices de-correlate (red circles and boxes), notice how the price spread between KO and PEP widens.

How might a pairs trader approach these price events?

Trade A: In September 2023, PEP’s stock price soared well above KO; the correlation, typically near 100%, fell to zero.

Trade B: By the end of January 2024, price correlations shifted from above 75% to -10% as PEP share prices dropped significantly relative to KO.

It’s worth noting, however, that it took three months for this trade to come to fruition. For a pairs trader looking for an arbitrage-type convergence, that’s a lot of time between trade initiation and liquidation, considering a pairs trade requires a short stock position.

The first two periods of noncorrelation between Coke and Pepsi resulted in a return to correlation. But what if you had repeated the process in June 2024 (trade C)? Notice that the spread didn’t stop at zero; it widened further to -25%.

Will prices converge, or has something fundamentally changed with either company that might cause the nature of the correlation to change? And at what point do you throw in the towel on this trade and close it out for a loss?

Pairs trading comes with an inherent risk that the price relationship between two stocks might change. This can happen due to significant financial challenges faced by an underperforming company, remarkable advances made by an outperforming company (making it difficult for its competitors to catch up), or other market-related conditions. For example:

The outcome of any of these situations will be dynamic and unknown, but the correlations are almost certain to change. And although that could spell trouble for the pairs trader who’s expecting a return of the old correlation, it could mean an opportunity for traders who follow fundamental shifts in the marketplace and position themselves for permanent decorrelation.

That’s another form of pairs trading.

What other stocks have been traded as pairs? Here’s a short list:

Remember: You can’t do a pairs trade unless you have a margin account—it’s required for anyone who wants to short sell stocks. And unless you’re an experienced trader who fully understands the risks of shorting stocks—and has the time, patience, and emotional wherewithal to monitor short positions—you might want to ease into pairs trading. Do your homework, study patterns, and learn the different types of pairs trading strategies you can use and the opportunities and risks they present.

And if your brokerage platform has a trade simulator (where you can practice with pretend money), start there.

Pairs trading assumes a consistent price relationship between two highly correlated stocks. But as the boilerplate financial disclaimer says, past performance does not guarantee future results.

This article is intended for educational purposes only and not as an endorsement of a particular financial strategy, company, or fund.