Pairs trading represents a short-term speculation strategy, that can be classified as statistical arbitrage. The basis of the strategy lies in finding two fundamentally highly correlated assets and under certain circumstances, matching them by opening approximately equal-sized positions against each other: one long, one short.
The given circumstance that signalizes us a possibility to make this arbitrage is an unusual divergence in price correlation of the two assets. In other words, when the price correlation between these two assets temporarily declines, for example, one of the assets´ price suddenly achieves a significant price increase, the strategy would be to short the outperforming asset and to long the underperforming. Based on historical price correlation, the investor bets, that the unusual price spread between these two assets will converge at last. The determination of a price deviation and fair spread value could be calculated by moving averages, regressions or other procedures.
The divergence in price correlation can be caused by various events such as a temporary change in demand, reaction to the earnings announcements or other company news, or high volume buy/sell orders by an institutional investor. The explanation of a pairs trading strategy also has a psychological background. The sudden divergence is often caused by investors´ over-reaction to the price moves of one asset. This is where the pair traders take advantage. By the rules of this strategy, the pair traders go against the stream knowing, that the prices will actually converge.
By the greatest upside of this strategy could be considered, that it can be applied in any market conditions. With going one position long and one short brings the investor market and sector neutrality, which means either up-trend, down-trend or sideways trend will bring the investor the same opportunity to profit. The most common pair-trading pairs are WTI and Brent crude oil, Coca-cola and Pepsi or sports brand Adidas and Puma.