Key Concepts

Pairs Trading

Pairs trading refers to trading a discrepancy in the correlation of two underlyings. For example, if XYZ is positively correlated to ZYX, and one is up 10 points while the other is down 10 points, we can assume that they will revert back to their positive correlation. There are many pairs out there, but we have a few guidelines we like to stick to.

Trade example: /ES and /NQ are highly correlated stock index futures. If there was a situation where /ES was up 1% but /NQ was flat, we might look to sell /ES while buying /NQ. The assumption in this trade is that the correlation breakdown between the pair is temporary and the movements would normalize.

At tastytrade we like to trade pairs for many reasons. One of which is the fact that it reduces our overall risk, given the known correlation of each underlying. It allows us to take advantage of cyclicality, and keeps us involved in periods of low IV. We are always sure to check that correlations have not detached before placing a trade, as this can happen from time to time.

Pairs Trading Videos