03. Pairs Trading

Pairs Trading

Note that with pairs trading, we analyze the original stock price series, and do not convert them to returns or log returns. We’ll get into the details shortly, but let’s just look at an example. Let’s say stock_A is $2 per share, and stock_B is $3 per share. If we figured out that we can trade these pairs together, we may go long stock_A and short stock_B . But how much do we long stock_A and short stock_B ? What if we long 3 shares of stock_A and short 2 shares of stock_B ? This is nice, because shares_A \times price_A - shares_B \times price_B gives us 3 \times \$2 - 2 \times \$3 , or zero. Doing pairs trading analysis with the stock price series instead of returns lets us decide how many shares of each stock to long or short, since our goal will be to have the same dollar amount in our long position as in our short position.