Using the Spearman Rank Correlation Coefficient traders can discover the strength of a link between the data of two related securities, spot discrepancies and take positions to profit from a reversion back to the mean. Pairs trading has been around since the existence of listed exchanges and has always been an effective market neutral trading strategy to capture a temporary price divergence between two securities. I first came across the idea of pairs trading many years ago when reading the fictionalized biography of Jesse Livermore, Reminiscences of a Stock Operator. This strategy is helpful when you are not sure whether the market is going to move up (or down) or if your risk aversion is high. The basic premise behind this strategy is to find highly correlated stocks and trade against their price convergence or divergence. You try to position yourself to take advantage of short-term discrepancies in prices, attempting to capture profits by spreading two securities while taking a small risk.
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