Pair Trading Strategy

Random stock pairs lack the statistical relationship needed for mean reversion. You need stocks that are fundamentally related (same sector, similar business) and statistically proven to have a cointegrated relationship. Without this, the spread can diverge permanently and never revert, causing losses.

For cash-based pairs: GBP 15,000-25,000 minimum to trade 2-3 pairs with proper position sizing. For leveraged spread-bet or CFD pairs: GBP 8,000-12,000 due to the built-in leverage. The key is having enough to diversify across multiple pairs while keeping each pair's risk at 2% of capital.

This is the main risk in pair trading. You have a stop loss at Z = 3.5 - if the spread widens beyond this, exit the trade and accept the loss. Also investigate why the spread diverged - it could be a structural break (M&A news, a demerger, etc.) that means the pair is no longer valid.

You can hold the long leg in cash shares, but shorting cash shares in the UK requires borrowing stock, which is impractical for most retail traders. The common UK approach is to take the short leg (and often both legs) via a spread bet or CFD, which allow easy shorting with built-in leverage. Start with whatever you're comfortable with, prioritising liquid instruments.

Daily monitoring of Z-score and correlation is recommended. Weekly deep review of cointegration status. Set alerts for the Z-score approaching exit targets (0.5) or stop levels (3.5). Pair trades are not set-and-forget - active monitoring is essential.

Avoid new entries 3-5 days before either stock's results. For existing positions, consider reducing size or tightening stops. Results can cause temporary divergence that eventually reverts, but can also trigger stop losses. Some traders close all pairs during peak reporting season.

Cash shares: no expiry, hold indefinitely, but shorting needs stock borrow. ICE single-stock futures: built-in leverage, easy shorting, but expiry requires rolling and contracts are a fixed 1,000 shares. Spread bets: tax-free for UK residents, sized in GBP per point (precise hedging), easy shorting, financing applies. CFDs: leverage and easy shorting, no SDRT, but CGT applies (losses relievable) plus financing. Options: defined risk and leverage, but theta decay and Greeks. Choose based on holding period, capital, tax position and comfort with derivatives.

Investigate the cause. Stock-specific news (a regulatory setback, a failed trial, a management change) may be permanent for that stock. Market-wide fear causing divergence is usually temporary. If correlation drops below 0.60 for more than two weeks without an obvious temporary cause, assume the relationship may have broken and exit.

Ratio spread is generally better - it's normalized for different price levels and more stable over time. Price spread works for similar-priced stocks. Beta-adjusted spread is most accurate for proper hedging. Start with ratio spread, graduate to beta-adjusted for precision.

Optimal is 5-8 pairs for diversification without over-complexity. Too few (1-2) = concentrated risk. Too many (>10) = difficult to monitor and manage, with diminishing marginal benefit. Ensure sector diversification - a maximum of 2 pairs from the same sector.

Generate all sector pairs from liquid stocks. Filter sequentially: correlation > 0.70, cointegration p < 0.10, half-life 3-25 days, stable relationship. Rank the remaining pairs by composite score (cointegration strength, half-life, stability, liquidity). Walk-forward validate. Rerun quarterly.

For pair selection: gradient boosting or Random Forest classification (profitable vs not). For entry timing: gradient boosting with Z-score features plus momentum and regime. For exit: reinforcement learning or supervised regression. Ensemble ML with traditional rules - use ML to filter, not replace, the fundamental logic, and never trade a signal blindly.

Calculate volatility (std dev of daily P&L) for each pair. Weight = 1/volatility, normalized to sum to 100%. Lower-volatility pairs (banking) get more capital; higher-volatility pairs (mining) get less. Rebalance monthly. This equalizes the risk contribution across pairs.

Track: (1) the average correlation among FTSE 100 constituents (high = trending), (2) the VFTSE level (>25 = elevated risk), and (3) market breadth (extreme = trending, mixed = mean-reverting). Combine these into a regime score, and adapt allocation and thresholds based on the regime.

Execute the less liquid leg first. Use algorithmic execution (TWAP/VWAP) for large sizes. Place limit orders to capture the bid-ask. Track slippage and execution cost - it should be less than 20% of expected profit. For very large positions, consider spreading execution over multiple days or using options.