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Pair Trade, also known as statistical arbitrage or spread trading, is a strategy that allows a trader to profit from anomalies as well as strong fundamental differences between two currency rates or asset portfolios while allowing for neutral market position. The key to this strategy is identifying correlated assets and using periods of price divergence while following the simple rules of entering and exiting the markets as well as being careful while managing ones capital.
While applying pair trading strategy at its basic form the trader works with two correlated stocks by selling the stocks that are falling in price and simultaneously buying others. Practically traders hedge themselves and, consequently, the overall market situation is not important. Thus, if the market declines then profits are made on falling stocks. When the market rises profits are made on advancing stocks. Naturally when we profit on one of the pair stocks we loose on the other. However this is the key to pair trading. Why is it profitable? Pair trading helps curb strong price fluctuations and increases market predictability. In other words, it creates a tougher and more predictable range for trading. While applying this strategy the most important thing for a trader is to wait and identify the moment when the price of a stock falls out of normal correlation.
Thus, the key difference of pair trading from other strategies is that you are not trading separate assets expecting them to go up or down, instead you focus on their price difference. This strategy is also called differential trading; you will immediately grasp the difference of pair trading from other strategies once you start applying it.
The markets have changed immensely during the last decade. They have become increasingly random, chaotic with short periods of relative stability when it is easier to predict their further development. Thus, a trader that attempts to predict general market or stock direction often is doomed to fail. Even experienced traders face situations that are contrary to their predictions. Many books that have been written in 90-ies, during the market bubble phase, present markets as chaotic but predictable formations. Unfortunately not all instruments that were effective then are equally effective now. However, the pair trading technology fits current markets and is worth paying attention to.