There are many different types of pairs trading. But when it comes to stocks, it typically means taking a long position in one company’s stock against a short position in another company’s shares. The purpose is to capitalize on diverging performance, while reducing exposure to the broad market.
Benefits: When an investor implements a pair trade, he is making a bet on the relative performance of one asset vs. another. As a result, the combined return of the pair trade can have little or no correlation with the broad market, hence it can be a great diversification tool. Unfortunately, investors are often told by their advisors they must hold many stocks to diversify their portfolios. While this is true, this strategy is not perfect. Why? Most advisors do not mention that in a bear market (when diversification is needed the most), your stocks are all highly correlated, i.e. they often all decline in value.
