Pairs Trading
Pairs trading means going long one asset and short a closely related one, betting on the gap between them rather than on the market's direction.
A pairs trade buys one asset and shorts a closely related one. If the gap between them returns to normal, the trade gains whatever the market does overall. The risk is that the relationship breaks and the gap keeps widening.
- Category
- Trading Strategies
- Reading time
- 3 min
- Also called
- Pair trade, Relative value trading, Statistical arbitrage pairs
- Updated
Pairs trading in plain words
In the classic research version, stocks are paired with the ones whose normalised price histories track them most closely.1
CMC Markets calls pairs trading a form of short-term statistical arbitrage.2
The skill lies in spotting when the two prices start to drift apart.2
How a pairs trade is built
Pick related assets
Find two assets that tend to move together — they can even come from different markets.2
Measure the gap
Track the price ratio or spread over time.
Wait for a stretch
Watch for the pair to diverge from its usual relationship.2
Go long and short
Buy the cheap one and short the rich one in matched sizes.
Set a limit
Exit if the gap widens past a set level.
Count costs
Account for trading frictions: some measured profits may come from market microstructure rather than true mispricing.1
Worked examples
Example 1 — Gap closes
ConvergedTwo hypothetical bank shares drift apart, then move back together.
| Gap at entry | Wide |
| Result | +1.5R |
Spotting when the assets are deviating in value set up the gain.2
Example 2 — Relationship breaks
Broken pairOne hypothetical company in the pair gets a takeover bid and the gap explodes.
| Gap | Kept widening |
| Result | −1R |
The pair needs a positive correlation between them; when that broke, the exit rule limited the loss.2
Example 3 — Costs bite
Cost dragA hypothetical pair trade gains slightly before fees and short costs.
| Gross result | Small gain |
| Net result | About flat |
Some of the paper profit may come from microstructure effects, so real trading costs matter.1
Pairs trading vs a single-direction trade
| Aspect | Pairs trading | Single-direction trade |
|---|---|---|
| Bet | Gap between two assets | Price goes up or down |
| Market exposure | Mostly offset | Full |
| Main risk | Relationship breaks | Wrong direction |
| Positions | Two legs | One |
Where pairs trading is used
Same-sector shares
Pairing two firms with high Correlation.
Market-neutral funds
Reducing overall Exposure.
Mean reversion
Applying Mean Reversion to a spread.
Hedged views
Using one leg as Hedging for the other.
Advantages and disadvantages
Advantages
- Less dependent on market direction.
- Clear rules for entry and exit.
- Can work in flat markets.
- One leg hedges the other.
Disadvantages
- Relationships can break.
- Two sets of costs.
- Shorting may be limited or costly.
- Gaps can widen for a long time.
Going deeper
Read as far as you need. Each level builds on the one before it.
What it is
Beginner
Pairs are chosen by how closely their normalised price paths have tracked each other.1
Statistical arbitrage
Intermediate
CMC Markets calls pairs trading a form of short-term statistical arbitrage.2
Costs and reality
Advanced
Part of the returns may reflect microstructure effects rather than a real edge, and short-selling rules differ by country.1
Common mistakes
Pairing unrelated assets
Correlation may be a coincidence.
No exit if the gap widens
Spreads can keep stretching.
Unequal sizing
One leg can dominate.
Ignoring short costs
Borrow fees reduce returns.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Pairs trading is long one asset and short another.
- It bets on the gap, not direction.
- It relies on a stable relationship.
- Relationships can break.
- Costs and short rules matter.
Frequently asked questions
Is pairs trading risk-free?
Do both legs need the same size?
Can I pair across markets?
Further learning
- Correlation
The heart of a pair.
- Mean Reversion
Why gaps may close.
- Hedging
How the legs offset.
- Backtesting
Testing a pair rule.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- NBER. Pairs Trading: Performance of a Relative Value Arbitrage Rule (Working Paper 7032) (opens in a new tab) Checked .
- CMC Markets. Pairs trading strategy (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.