What is a Pairs Trade?
A pairs trade occurs when an investor buys two stocks in the same industry.
How Does a Pairs Trade Work?
Let's say John Doe buys shares of Ford and General Motors. The stocks tend to follow the same patterns -- they tend to rise at the same time and fall at the same time.
However, if Ford starts to rise while General Motors starts to fall, the strategy requires John to sell Ford and buy more GM. The theory is that the stocks will eventually 'synch up' and resume their tandem trading patterns, which means John can profit by buying the stock that is temporarily depressed (GM) and selling the stock that is temporarily peaking (Ford).
Why Does a Pairs Trade Matter?
Pairs trades allow investors to mitigate the effects of broad market trends as is generally considered a market-neutral approach. It can apply to bonds, options and other securities in addition to stocks. It is important to note, however, that the strategy relies on the notion that the two securities will continue to trade in lockstep with each other and that any divergence is only temporary.