Unleash Your Inner Quant Why Pairs Trading Is The Go To Medium

Leo Migdal

-Dec 4, 2025, 5:43 AM

unleash your inner quant why pairs trading is the go to medium

Pairs Trading Strategy involves being neutral to the direction of the market. This article looks at what pairs trading is, how it works, and its advantages and disadvantages (pros and cons). The main benefit of pairs trading is market neutrality. In the end, we test some simple pairs trading strategies. Pairs trading is profitable and still working. Pairs trading strategies involve market-neutral strategies that aim for profits in any type of market, be it sideways, down, or up.

Jim Simons’ The Man Who Solved The Market describes the origin of pairs trading: at Morgan Stanley in the 1980s. Small independent traders have used the same techniques, especially at proprietary firms because pairs trading needs leverage to efficient. Pairs trading could be done in a wide range of instruments, for example, gold and silver, but in this article, we look at pairs trading in the stock market. To have a pair you need to have two stocks, of course, and look at their historical performance and co-movement. When the price difference between the two stocks weakens, for example, one stock rises more than the other, the idea is to short the strongest one of the pair and buy the weakest one. Of course, a pairs trade could also do the opposite.

There is no definitive answer to what is the best method. The price differential is called the “spread”. The spread converges and diverges and the idea is most of the time to go against those swings in the belief the spread will converge after it has diverged. Pairs trading sits at the crossroads of statistics and markets: instead of predicting where prices will go, you exploit relationships between two securities and profit when those relationships temporarily drift and then mean-revert. This post kicks off a short series on pairs trading. We’ll start with the core intuition using a simple synthetic example, turn that into a tradable set of rules, run a toy backtest, and then move from toy to real by examining the classic...

Finally, we’ll stress-test distance-based pairs on real data, discover why sample-out performance often disappoints, and explore practical improvements. At its heart, pairs trading is a relative-value strategy: You look for two instruments whose prices are driven by similar underlying risks (sector, factor exposures, supply chains, regulation, etc.). Over long horizons, their prices (or appropriately transformed series) tend to move together. When the relationship deviates, you bet on a reversion toward that equilibrium by going long the cheap leg and short the rich leg. 6.

Risk Management and Optimization in Pairs Trading 7. Assessing the Viability of Pairs Trading 8. Challenges and Limitations in Pairs Trading Strategies Pairs trading is a fundamental strategy in quantitative finance, offering investors a unique approach to navigate the complexities of financial markets.

Often regarded as a market-neutral strategy, pairs trading hinges on the idea of exploiting relative price movements between two related assets. It's an approach that has piqued the interest of both seasoned professionals and aspiring quantitative analysts, and for good reason. As we delve into the intricate world of pairs trading, we'll explore its principles, strategies, and the mathematics that underpin this fascinating aspect of quantitative finance. Pairs trading, at its core, is a market-neutral strategy. The fundamental premise is to identify two assets that exhibit a historical price relationship, often moving in tandem. When this relationship falters and one asset deviates from its expected pattern, the pairs trader takes advantage of the mispricing.

An excellent example is the classic pairing of two competing companies in the same sector, such as Coca-Cola and PepsiCo. If historical data shows that these two stocks often move in the same direction, a pairs trader would take long and short positions to capitalize on any divergence. I have started working on pairs trading and market-neutral trading strategies in the US equity market over the last few months. Here, I will try to give a clear and concise introduction to the topic and introduce the frameworks I will be delving into more deeply in the next posts. Before speaking of pairs trading, let’s first define market-neutral strategies. A market-neutral strategy aims to provide uncorrelated sources of returns from the market.

The Capital Asset Pricing Model (CAPM), even if now outdated, provides a nice framework to explain the intuition: The return of an asset can be expressed as $r_t - r_f = \alpha + (\beta \times (r_m - r_f)) + \epsilon_t$, with: With this framework, if you manage to construct a portfolio with a null beta (i.e., the linear combination of the assets within is such that the sum of their betas is null), you then... The quant researcher’s role is thus to reduce its strategy’s beta as much as possible and to maximize its alpha (i.e., its expected outperformance). Bear and bull markets don’t matter anymore! But what’s the point?

Why not just buy OTM calls with one week until expiration and pray to get rich? Joke aside, why not just be a bullish investors and be directional ? Warrent Buffet for sure isn’t a market neutral player. The pair trading strategy is a market-neutral approach that helps traders to benefit from the historical price relationships between two related assets. It’s about buying and selling two assets simultaneously. These assets usually maintain a stable price relationship, and traders profit from temporary price deviations.

This article offers a comprehensive insight into the pair trading strategy with examples and applications to enhance your trading skills. Pair trading hinges on the fact that certain assets, like stocks from the same industry or commodities, maintain a historical price relationship. This relationship remains stable over time. Traders watch out for temporary deviations from this historical relationship. They then take long and short positions on the respective assets, expecting the price relationship to revert to its usual pattern. Price Relationship: This is the historical price relationship between two related assets, expected to remain stable over time.

Temporary Deviations: These are short-term price discrepancies between related assets. These deviations provide profitable opportunities for pair traders. Market-Neutral Approach: Pair trading is a market-neutral strategy. It involves taking both long and short positions, reducing exposure to overall market movements. Stock Trading: A trader spots two stocks in the same industry with a strong historical price relationship. If one stock temporarily becomes overvalued compared to the other, the trader may sell the overvalued stock and buy the undervalued one.

The expectation is that the price relationship will return to its historical norm. Commodity Trading: A trader observes a temporary deviation in the price relationship between two related commodities, such as gold and silver. The trader may take long and short positions in the respective commodities, expecting the price relationship to return to its historical average. Pair trading is applicable across various asset classes and market conditions. Here are some applications:

Unleash Your Inner Quant Why Pairs Trading Is The Go To Medium

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