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Yesterday I covered the basics of pairs trading and why it’s a popular strategy for traders who want to hedge their bets in an unpredictable market environment like we’ve been seeing lately.
I explained how pairs trading works by going long on one stock and short on another stock in the same sector, allowing you the chance to profit based on how they move in relation to each other.
Now that you’ve got the fundamentals down, let’s dive a bit deeper. In this next section, I’ll show you how to navigate pairs trading in different market conditions and share some key tips to help you get started with confidence.
When to Use Pairs Trading
Pairs trading can work in a variety of market conditions, but it really shines in markets that are choppy or hard to predict.
If the overall market is volatile — like we’ve seen lately with one day’s gain turning into the next day’s loss — pairs trading gives you a way to stay active without betting the farm on one stock’s direction.
In a sideways market, where stocks are moving up and down without any clear trend, pairs trading helps you hedge your bets. If one stock in your pair moves against you, the other is likely to make up for it.
What to Watch Out for as a Beginner
If you’re new to pairs trading, the most important thing to remember is that you’re not just trading two individual stocks — you’re trading the relationship between them.
That means it’s crucial to pick two stocks that are correlated, or that tend to move together in a predictable way.
Also, keep an eye on time decay. In pairs trading, time decay can eat into your profits if both stocks stay flat.
This is especially true if you’re trading options on both stocks, as options lose value over time if the stock price doesn’t move.
Finding Correlated Stocks for Pairs Trading
In pairs trading, the goal isn’t to find stocks that move in completely opposite directions, but rather to find two stocks that usually move in the same direction. These stocks are said to have a high positive correlation — typically close to +1.
Here’s where the opportunity lies: when two correlated stocks move out of sync — meaning one stock performs better than usual and the other underperforms — you can step in and trade based on the expectation that their prices will eventually come back together.
Many traders use a correlation coefficient to measure the relationship between two stocks. A high correlation (around +1) indicates that the stocks usually move together. The key in pairs trading is spotting temporary deviations from this correlation.
For example, if two stocks normally have a correlation of 0.95, but suddenly they diverge and their correlation drops to 0.50, you could go long on the underperforming stock and short on the outperforming stock. As their prices realign, you profit from the difference.
Most trading platforms, like Thinkorswim, have tools that allow you to check correlations between stocks. You can also use websites like Investing.com to compare how two stocks normally move together and identify opportunities when they diverge.
Key Takeaways | | • | | Pairs trading helps hedge your risk by taking advantage of price differences between two related stocks. | | | • | | You don’t need both stocks to move in opposite directions to make money — just enough of a difference to profit from one outperforming the other. | | | • | | Pairs trading is great in uncertain or sideways markets because you don’t have to rely on one stock’s performance. | | | • | | Beginners should focus on finding correlated stocks and be mindful of time decay when trading options. |
So whether you’re dealing with a choppy market or just want to hedge your bets, pairs trading could be a great strategy to add to your toolbox.
The key is understanding how it works and using it in the right conditions.
— Geof Smith
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