PairsTrading

Pairs trading is a market-neutral trading strategy that simultaneously takes a long position in one security and a short position in a correlated security. When the price relationship between the pair diverges from its historical norm, pairs traders bet on convergence—going long the underperformer and short the outperformer. Profits come from the spread normalizing, regardless of overall market direction.

How Pairs Trading Works

Pairs trading exploits temporary divergences in correlated securities:

Pairs Trading Logic:
1. Identify two highly correlated stocks (e.g., Visa & Mastercard)
2. Calculate their historical price ratio (spread)
3. When spread deviates 2+ standard deviations:
   - Short the outperformer
   - Long the underperformer
4. Exit when spread reverts to mean
5. Profit regardless of market direction

Quick Reference: Pairs Trading Setup

Element	Description	Target
Correlation	How closely pairs move together	> 0.80
Cointegration	Statistical relationship over time	Must pass test
Spread entry	Standard deviations from mean	2+ SDs
Spread exit	When spread normalizes	0-0.5 SDs
Holding period	Time for spread to converge	Days to weeks

Example: HDFC Bank vs. ICICI Bank Trade

Setup: Both banks trade together historically (correlation 0.85)

Observation:

• HDFC Bank: Up 8% this month
• ICICI Bank: Up 2% this month
• Spread: 2.3 standard deviations from mean

Trade:

• Short ₹5 lakh of HDFC Bank
• Long ₹5 lakh of ICICI Bank
• Net market exposure: Zero

Two weeks later:

• HDFC Bank: Flat (from your short entry)
• ICICI Bank: Up 4% (from your long entry)
• Spread has normalized

Result:

• Short leg: Break-even
• Long leg: +4% = ₹20,000 profit
• Total: ₹20,000 on ₹10 lakh deployed

Finding Tradable Pairs

Criteria for Good Pairs:

1. Same industry – Affected by similar forces
2. High correlation – 0.80+ over long periods
3. Cointegrated – Statistical test for long-term relationship
4. Sufficient liquidity – Can enter/exit both legs easily
5. Borrowable – Shares available to short

Popular Pairs in Indian Markets:

• HDFC Bank / ICICI Bank
• Reliance / ONGC
• TCS / Infosys
• Maruti / Tata Motors
• SBI / Bank of Baroda

The Spread Calculation

Price Ratio Method:

Spread = Price of Stock A / Price of Stock B
Normal Ratio: 1.25 (historical mean)
Current Ratio: 1.40 (Stock A outperforming)
Deviation: 12% from mean (trade signal)

Z-Score Method:

Z-Score = (Current Spread - Mean) / Standard Deviation
Z > 2: Short A, Long B
Z < -2: Long A, Short B
Exit when Z returns to 0

Risk Management in Pairs Trading

1. Position Sizing

Equal dollar amounts on each leg. If one stock is more volatile, adjust for equal beta exposure.

2. Stop Loss

Set max spread deviation. If spread hits 3-4 standard deviations, the relationship may be broken.

3. Time Stop

If spread doesn’t converge within expected period (e.g., 30 days), exit and reassess.

4. Correlation Monitoring

Track correlation in real-time. If it’s breaking down, exit the position.

Why Pairs Trade?

1. Market-neutral – Don’t need to predict market direction

2. Reduced volatility – Hedged position has lower variance

3. Works in any market – Bull, bear, or sideways

4. Statistical edge – Mean reversion is a documented phenomenon

Common Mistakes

1. Ignoring cointegration – High correlation isn’t enough. Pairs must be statistically cointegrated to mean-revert.

2. Unequal position sizes – Both legs must be equal in value (or risk) for proper hedging.

3. Fighting permanent divergence – Sometimes the relationship breaks. Companies change. Cut losses when the thesis is broken.

4. Ignoring borrow costs – Short positions have costs. Factor them into profitability.

How JournalPlus Tracks Pairs Trades

JournalPlus tracks both legs of your pairs trades as a combined position, calculating net P&L, spread entry/exit levels, and whether your pairs are converging as expected. You can monitor correlation between your paired positions over time.