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Chapter 15 Pairs Trading Portfolios

“A drunk man will find his way home, but a drunk bird may get lost forever.”

— Shizuo Kakutani

Pairs trading is a relative-value arbitrage strategy that has been known in the quantitative finance community since the mid-1980s. It seeks to identify two securities whose prices tend to stay together. Upon divergence, the undervalued security is bought long and the overvalued one is sold short, which is typically referred to as a contrarian philosophy (buy when everyone else is selling and vice versa). When the prices revert back to their historical equilibrium, the trade is closed and a profit is realized.

Mathematically, the two assets are combined into a virtual asset with mean reversion, that is, having an historical equilibrium value to which it eventually reverts. A key property of pairs trading is that it exploits the relative mispricings between the two securities while maintaining market neutrality (i.e., not being affected by the market trend). This is in contrast to momentum-based strategies, which precisely try to capture the market trend while treating the fluctuations as undesired noise. The extension of pairs trading to more than two assets is referred to as statistical arbitrage.

In a nutshell, while momentum-based strategies capitalize on the price trend, pairs trading exploits the mean-reverting fluctuations around that trend. This chapter starts with the basic concepts and covers the whole process, from discovering pairs to trading them based on sophisticated Kalman modeling techniques.

This material will be published by Cambridge University Press as Portfolio Optimization: Theory and Application by Daniel P. Palomar. This pre-publication version is free to view and download for personal use only; not for re-distribution, re-sale, or use in derivative works. © Daniel P. Palomar 2025.