PairAlpha

What is Pairs Trading?

Pairs trading is a market-neutral trading strategy that matches a long position in one stock with a short position in another related stock. The strategy is based on the concept that the two stocks have a historical price relationship that can be expected to revert to the mean over time.

Advantages of Pairs Trading

Compared to other strategies, pairs trading offers several benefits:

• Market-neutral approach reduces exposure to overall market risk
• Works in various market conditions, including sideways markets
• Can be less volatile than directional strategies
• Provides natural hedging through the paired positions

Important Considerations

Ticker Order Matters: The order of tickers (Stock 1 vs Stock 2) affects analysis results, including Z-scores and trading signals. This happens because the regression equation is asymmetric:

• Stock1 = Alpha + Beta × Stock2

For optimal results, follow these guidelines:

• For market pairs: Place individual stocks as Stock 1, and ETFs/indices as Stock 2
• For similar stocks (e.g., Pepsi/Coke): Place the more volatile stock as Stock 1
• Stock 1 is modeled as being influenced by Stock 2's movements

How to Use This Tool

Enter any two stock tickers to analyze their historical relationship. Cointegration testing checks if the pair maintains statistical equilibrium, essential for pairs trading. Charts display performance, price ratio, and spread over time.

Selecting the Right Timeframe

The timeframe you select affects all analysis results:

• Shorter (1-3 months): More responsive to recent market changes but may miss longer-term relationships
• Medium (4-12 months): Good balance for most pairs trading; captures seasonal patterns
• Longer (12-24 months): Better for identifying stable, long-term relationships but may include outdated market conditions

Start with 6 months and adjust based on the pair's volatility and trading frequency.

Tips for Better Results

• Look for stocks in related sectors or with similar business models
• Focus on pairs with strong cointegration (p-value < 0.05)
• Prefer pairs with shorter half-life values (faster mean reversion)
• Compare results across multiple timeframes to confirm stability
• For Z-scores: values below -2 suggest Stock 1 is undervalued relative to Stock 2 (potential buy signal)
• For Z-scores: values above +2 suggest Stock 1 is overvalued relative to Stock 2 (potential sell signal)
• Consider market cap, liquidity, and options availability for practical trading