The pairs trade or pair trading, also known as market neutral, was developed in the late 1980s by quantitative analysts and pioneered by Gerald Bamberger while at Morgan Stanley. With the help of others at Morgan Stanley at the time, including Nunzio Tartaglia, Bamberger found that certain securities, often competitors in the same sector, were correlated in their day-to-day price movements. When the correlation broke down, i.e. one stock traded up while the other traded down, they would sell the outperforming stock and buy the underperforming one, betting that the "spread" between the two would eventually converge.

Some real-life examples of potentially correlated pairs:

• Dow Jones (^DJI) and S&P500 (^GSPC)
• Coca-Cola (KO) and Pepsi (PEP)
• Wal-Mart (WMT) and Target Corporation (TGT)
• Dell (DELL) and Hewlett-Packard (HPQ)
• Alliance and Leicester (AL.L) and Royal Bank of Scotland (RBS.L)
• Portugal Telecom (PTC.LS) and Telefonica (TEF.MC)
• Banco Comercial Português (MBC.LS) and Banco Português de Investimentos (BPI.LS)

The pairs trade helps to hedge sector- and market-risk. For example, if the market as a whole crashes and your two stocks plummet along with it, you should experience a gain on the short position and a negating loss on the long position, leaving your profit close to zero in spite of the large move. In a pairs trade, you are not making a bet on the direction of the stocks in absolute terms, but on the direction of the stocks relative to each other.

Algorithmic pairs trading

Today, Pairs trading is often conducted using algorithmic trading strategies on an Execution Management System. These strategies are typically built around models that define the spread based on historical data mining and analysis. The algorithm monitors for deviations in price, automatically buying and selling to capitalize on market inefficiencies. The advantage in terms of reaction time allows traders to take advantage of tighter spreads.

Drift

The difficulty with pairs trading comes when the two stocks begin to drift apart. Unless the relative prices return closer to their historical levels, the pair trade will not be profitable. Consequently pair traders can support each others actions by buying the downward drifting stock restoring the relative prices.

Hedging and Arbitrage

When pairs trading is performed between a stock and its derivatives, or between technically related stocks, it is termed hedging. Pairs trading across related symbols in different currencies is termed arbitrage. Software can be used to calculate sophisticated relationships between indices, baskets, stocks and currencies.

Pairs trade Topic - Options

In finance, an option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular asset (the underlying asset) on or before the option's expiration time, at an agreed price, the strike price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A call option gives the buyer the right to buy the underlying asset and a put option gives the buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, a security (stock or bond), or a derivative instrument, such as a futures contract.