Pairs trading is a trading strategy that uses a short position and long position of two different stocks in the same sector simultaneously.
This is based on the concept that the two stocks have close correlation and concur to convergent and divergent cycles. If the prices of the two stocks correlate, most of the time the price per share of Share X divided by price per share of Stock Y should be relatively consistent.
When divergence occurs, one comes up while the other goes down. The trick here is to short sell the outperforming stock while buying long the underperforming stock, in anticipation that the spread in between the two will converge. If convergence does not happen, this will not be a profitable trade, which is a risk the investor undertaking pairs trading have to bear. This market-neutral strategy is only interested in the direction of the two stocks in relation to each other and helps to hedge against sector and market risk.
So to begin the pairs trade, choose two stocks in the same sector that correlates closely. After identifying the range in which they typically trade in, the investor can then spot the point of entry when divergence occurs beyond this range. The investor then simultaneously short sells the outperforming stock while buying long the underperforming stock. When convergence occurs again, it is time to close out the positions. Be mindful of holding costs as pair trades tend to be longer term in nature as divergences might stay on for an uncertain period of time.