Pairs trading

TLDR

Pairs trading is a hedge‑fund strategy that exploits the spread between two similar stocks. This paper develops an analytical framework for pairs trading. The authors model the spread as a mean‑reverting Gaussian Markov chain observed in noise, calibrate it, and use its predictions to time short‑high/long‑low trades that profit as the spread reverts to equilibrium. The approach can generate wealth from any financial assets that deviate from equilibrium.

Abstract

'Pairs Trading' is an investment strategy used by many Hedge Funds. Consider two similar stocks which trade at some spread. If the spread widens short the high stock and buy the low stock. As the spread narrows again to some equilibrium value, a profit results. This paper provides an analytical framework for such an investment strategy. We propose a mean-reverting Gaussian Markov chain model for the spread which is observed in Gaussian noise. Predictions from the calibrated model are then compared with subsequent observations of the spread to determine appropriate investment decisions. The methodology has potential applications to generating wealth from any quantities in financial markets which are observed to be out of equilibrium.