Broadly speaking, pairs trading entails betting on two stocks either moving away from each other or converging on each other in price. This is done by buying or selling one market and then doing the opposite in a market that generally moves in the same direction as the first market.
Using the Russell 2000 and the S&P 500 as an example, Tom and Tony cover both the reasoning behind why we pairs trade and how it is done.
To kick off the segment, the guys go through the following reasons for initiating pairs trades:
- Take advantage of that have diverged in price
- Reduce risk by trading a spread that tends to be uncorrelated to the individual stocks
After this introductory note, Tom goes through all the steps required to create a pairs trade starting with simply finding a correlated pair of stocks and finishing with calculating the contract ratios that match the.
Check out the segment above for a step-by-step description of how to set up a pairs trade in stocks.