Pair Trading Signal Analysis
Test whether two stocks move together closely enough to trade the gap between them — and what that would have returned.
New to pair trading? Start here
Two companies in the same business — say two IT firms — usually rise and fall together, because the same things affect both. Their share prices stay in a rough proportion to each other.
Occasionally that proportion stretches: one gets expensive relative to the other for no lasting reason. Pair trading bets that the gap closes. You sell the expensive one and buy the cheap one at the same time, then close both when the gap narrows.
Because you are long one and short the other, it matters far less whether the market as a whole goes up or down — you are betting on the gap, not the direction. That is the appeal.
The catch:it only works if the two prices genuinely pull back together. If they drift apart permanently — one company wins, the other declines — the “cheap” one keeps getting cheaper and both legs lose. That is what the test on this page is for, and it fails more often than it passes.
Selling a share you do not own is short selling. In India you cannot hold a short overnight in the ordinary cash market, so any multi-day pair trade requires futures — which uses margin, and losses can exceed the amount you put in.