What is pair trading? The pair trading is the choice of any two correlated assets, mainly equities, which history shows travel together. The trader holds the relationship between the pair and waits for divergence greater than a certain threshold; once the divergence is higher than that threshold, the trader begins to go long on what underperformed and short sell on what outperformed, since the price correlation should mean-revert over some period of time.

For example, if two equities are from the same industry, such as Coca-Cola KO and PepsiCo PEP, they have had a history of moving with each other. When Coca-Cola's price drops but that of PepsiCo increases, then a pair trader goes long on Coca-Cola and shorts PepsiCo as an expectation that Coca-Cola will catch up with PepsiCo in a short period or vice versa.

How Pair Trading Works

1. Select the Pair: The beginning of pair trading is two commodities that have proven to have good correlation in history. They fall under the same sector because the two tend to…