Pairs Trade Example.
Just as long-only stock traders scan the markets for suitable securities, a pairs trader must start with a list of potentially related pairs. This entails conducting research to find securities that have something in common – whether the relationship is due to sector (such as the auto sector ) or to asset (for example, bonds). While any random pair could theoretically be correlated, it is more likely that we will find correlation in securities that have something in common to begin with.
The next step acts as a filter, or a means by which we can reduce the number of potential pairs in our quiver. One way is to use a correlation coefficient to determine how closely two instruments are related. Figure 4 shows a daily chart of the e-mini S&P 500 contract (in red) and the e-mini Dow contract (in green). Below the price chart is an indicator that shows the correlation coefficient (in yellow). We can see from the chart that during the time period evaluated, the ES and YM are highly correlated, with values hovering around 0.9. We will keep the ES/YM pair on our list of potential pairs candidates.
Figure 4 The e-mini S&P 500 contract (in red) and the e-mini Dow (in green) show potential as a pairs trade. Visual confirmation of price, backed by quantitative results from the correlation coefficient (in yellow), show that the two instruments are highly correlated. Image created with TradeStation.
Figure 5 This daily chart of WMT (in red) and TGT (in green) shows that this is not an ideal pair (at least not during the time period tested). A visual review of prices, confirmed by results from the correlation coefficient (in yellow) indicate a lack of correlation between the two stocks. Image created with TradeStation.
An ongoing component of the process is to research and test trading ideas and determine absolute methods of evaluating pairs and defining divergence. Traders will have to answer questions like What constitutes “enough” divergence from the trend to initiate a trade? and How will this be evaluated (for example, using data from a price ratio indicator with standard deviation overlays). In general, traders should focus on quantifiable data: i. e., “I will enter a pairs trade when price ratio exceeds two standard deviations.” Figure 6 shows two ETFs – SPY (in red) and DIA (in green) – on a daily chart. Below the price chart is a spread ratio indicator (in blue), with a +/- one and two standard deviation overlay (dotted lines). The mean appears in pink.
Figure 6 A daily chart of the ETFs SPY (in red) and DIA (in green). A spread ratio indicator appears below the price chart, along with a standard deviation overlay. Image created with TradeStation.
Many traders use a dollar-neutral approach to position sizing when trading pairs. Using this method, the long and short sides of the trade are entered with equal dollar amounts. For example, a trader wants to enter a pairs trade with stock A, trading at $100 per share, and stock B, trading at $50 per share. To achieve a dollar-neutral position, the trader will have to purchase two shares of stock B for every one share of stock A. For example:
Long 100 shares of stock A = $10,000; and Short 200 shares of stock B = $10,000.
Buy the underperformer and sell the overperformer.
Once the trading rules are met, the trader will buy the underperforming security and simultaneously sell the overperforming security. In Figure 7, the spread ratio has exceeded two standard deviations, and a trading setup has occurred in our ES/YM pair. Here, a long position is entered with two ES contracts, and a simultaneous short position of two contracts is taken in the YM.
Figure 7 A trade is opened in the ES/YM pair. The order entry interface appears on the left side of the screen (one order entry box for the ES; one for the YM). The horizontal red and green lines at the top show the real-time P/L for each position. Image created with TradeStation.
As with most investments, the timing of the exit is critical to the success of the trade. It is important to apply money management principles to pairs trades, including the use of protective stop-loss orders and profit targets. Optimal levels are typically determined through extensive historical modeling. Figure 8 shows the ES/YM trade, exited using a conservative net profit level.
Figure 8 The ES/YM trade is exited with a small net profit. Image created with TradeStation.

Pairs Trading: Market Neutral Investing.
The various market-neutral strategies invest in different asset types; for instance, convertible arbitrage takes long positions in convertible securities and short positions in common stock. As another example, merger arbitrage takes long and short positions in the stocks of companies involved in mergers. Market-neutrality can be achieved either at the individual instruments level or at the portfolio level. While the strategies are very different, both in terms of assets and methodology, they all fall under the market-neutral umbrella. This is because each derives returns from the relationship between a long and a short component – either at the individual instruments level or at the portfolio level.
Because one position is taken in conjunction with another position to reduce directional exposure, market-neutral strategies often provide a hedge against market risk. In this manner, exposure to the market is exchanged for exposure to the relationship between the long and short positions. This does not imply that market-neutral investing is risk-neutral or even risk-free (it is neither); however, the risks are different than those associated with directional, long-only investing. A market-neutral approach provides an alternative and uncorrelated source of returns when used as part of (but not as a substitute for) an overall investment strategy.

Introduction to Dollar-Neutral Pair Trading.
Dollar-Neutral Pair Trading entails establishing simultaneously both a long and short position in two stocks with each position having the same absolute dollar amount. This strategy seeks to generate significant and consistent returns while controlling risk by maintaining a low correlation to broader market averages. This market-neutral strategy is meant to profit regardless of whether equities rise or fall.
You can easily evaluate a pair trade by selecting two companies with similar characteristics and then using the Catalyst Corner Pair Trading Model to determine if they are trading outside of their historical trading range. Typically an investor will buy the oversold issue and short sell the overbought issue the goal being for the spread between the two equities to retrace to their historical trading mean. You can profit by either the long increasing in price, the short decreasing in price, or both. Losses result from diverging prices of the paired securities.
Enjoy the e-book which is educational and insightful and provides examples of pair trades and a free pair trading tool to help you get started! Good luck.
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Dollar neutral trading strategy

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Dollar-Neutral Strategy.
Here is an excerpt from E. Chan's book Quantitative Trading,
However, if the strategy is a long-short dollar-neutral strategy (i. e., the portfolio holds long and short positions with equal capital), then 10 percent is quite a good return, because then the benchmark of comparison is not the market index, but a riskless asset such as the yield of the three-month U. S. Treasury bill (which at the time of this writing is about 4 percent).
I do not understand why a long-short strategy is riskless - AFAIK in a short-long position with equal dollar amount in each, the short would pay for the long, but how does that translate into risklessness?
Long-short strategy is generally used by hedge funds. In simple words, an equity long-short strategy means buying an undervalued stock and selling(shorting) an overvalued stock. In normal circumstances, the long position will increase in value and the short position will decline in value. In this situation, the hedge fund will benefit. This strategy would work even if the long position declines in value but provided that the long position outperforms the short position.
Thus, the goal of any equity long-short strategy is to minimize market exposure, and get profit from a change in the difference between two stocks.
Let's take a simple example. A hedge fund takes a \$10 million long position in General Motors and a \$10 million short position in Volkswagen, both large automobile companies. With these positions, any event that causes all automobile stocks to fall will lead to a loss on the General Motors position and a profit on the Volkswagen position. Similarly, an event that causes both stocks to rise will have little effect, since the positions balance each other out. So, the market risk is minimal . But question arise, Why would a portfolio manager take such a position? Because he or she thinks General Motors will perform better than Volkswagen.
Equity long-short strategies which hold equal dollar amounts of long and short positions, are called market neutral strategies or long-short dollar neutral strategy (as described above).
Since, portfolio is immune to both upside and downside market risk , like risk free security, its performance must be measure from similar security ie riskless assets such as U. S. Treasury bill etc.
You can read more about market neutral strategy from here.
They are not riskless and a TBill is not the right benchmark comparison. While a dollar neutral long/short portfolio does provide enhanced risk management, the extent is dependant upon the composition of the portfolio. For example, if long 10M IBM and short 10M XOM, what have you hedged ? What is the relationship between IBM and XOM ?
In this example you are hedging broad market (Beta) changes but nothing specfic to the sector or stocks.
For a benchmark you cannot use the TBill. For this imaginary portfolio to fail, all that is needed is bad news from IBM (or technology sector) and Oil issues (oversupply anyone ?). My point is that long/short does reduce risk and is a great strategy but you have to understand the portfolio to understand its risks.