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 maintains a statistical equilibrium (cointegration) which can be expected to revert to the mean over time when temporary deviations occur.

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.

All analyses are currently based solely on daily close data. If you're trading on shorter timeframes (e.g., intra-day or swing trading), consider supplementing this daily close analysis with real-time or intraday data to refine entry and exit points. For most position or medium-term strategies, however, daily close data often provides a sufficient view of broader market trends.

Selecting the Right Timeframe

The timeframe you select affects all analysis results:

• Shorter (6-12 months): Responds more quickly to recent market changes but can miss longer-term trends
• Medium (12-24 months): Provides a balanced view, capturing both short-term dynamics and seasonal patterns
• Longer (24-36 months): Ideal for identifying stable, long-term relationships, though it may include outdated market conditions

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 below -2, Stock 1 is undervalued (buy), and above +2, it's overvalued (sell), relative to Stock 2
• Consider market cap, liquidity, and options availability for practical trading