When a trader takes different position on two stocks in the market it is known as ‘pairs trade’. In pair trading the trader goes long in one stock and short in another stock. It is very pertinent to mention the selection of stocks are not that easy and it requires many statistics technique to build up the pair trade position on the selected stocks.
If executed properly, even when both stocks are up, the stock in which you were long will go up much faster than the stock in which you were short. And, when both stocks are down, the stock you were short will decline faster than the stock you were long.
Since selection of stocks in pairs trade is complex, correlation plays very important role here. Once correlation is established between the two stocks then trading is a cake walk.
Lets say, the trader zeroed down on Google and Yahoo, so if both the stocks move up and down at the same time then the correlation will be positive (+1). If Google move up and Yahoo move down at the same time then the correlation will be negative (-1). If both stocks move randomly then there will be no correlation (0).
How to get correlation? You will get correlation by dividing covariance of the percentage change in stock price by product of standard deviations of the two stock. Ideally, traders chose those stocks pair were correlation is 0.80 or above as it gives a very consistent relationship. When this correlation breaks or weakens i.e. Google moves up on the other hand Yahoo moves down, the trader bets on the price spread of these two stocks. When you decide to use correlation make sure that data taken is for more than six month or so. We can use beta as one more tool to do pair trading. Happy trading!