Pair trading, or statistical arbitrage, is a stock trading strategy that seeks to effectively create a neutral position and capture the spread between two correlated stocks that trade either above or below their mean price. Two stocks whose prices move in opposite direction are strong candidates for pairs trading. In such a case, a trader buys Stock 1 and sells Stock 2 short. Essentially, the trader buys Stock 1 with the expectation of a price increase and simultaneously enters a trade to sell Stock 2 at a high price before buying it back later at a lower price.
Set up a stock watch list. You may use your online brokerage account to establish a list of stocks of interest. You may also use Yahoo! Finance to search for stock pairs. Look for stocks that are trading above or below their 52-week moving average. Most trading programs allow you to customize the range to a 20-week moving average.
Confirm correlation by creating charts for the two stock pairs. Your trading software allows you to chart stock prices of two or more stocks on the same graph. This gives you a good visual representation of the correlation of the two stocks.
Create a price ratio chart. This is not as complicated as it may seem. Most trading platforms create price ratio charts for you automatically. While eyeballing price charts is a good starting point, a price ratio chart goes one step further. Not only does it chart both stocks plotted together, it divides one stock price into the other. The effect is a line chart that measures the deviation from the mean or average spread between the stock pairs.
Buy one stock and sell the other short. Initiate a trade when the price ratio moves into its first or second deviation from the average or mean. You want to buy the one stock that is lagging below its mean and sell the other stock that is overperforming above its mean.