What is statistical pairs trading?

• A. A strategy involving one short position in a sector
• B. A trading strategy that involves one long and one short position in closely related securities
• C. A method of analyzing individual stock performance
• D. A strategy focused solely on technological stocks

Answer: (B)

Statistical pairs trading is a market-neutral trading strategy that seeks to exploit the relative price movements between two closely related securities. The fundamental idea behind this strategy is to take a long position in one security while simultaneously taking a short position in another security that is perceived to be correlated or related. This relationship allows the trader to capitalize on the mispricing between the two securities, regardless of the overall market direction.

By focusing on closely related securities, pairs trading attempts to mitigate market risk by neutralizing the broad market movements. For instance, if one stock is underperforming or overperforming compared to another, a trader might buy the undervalued stock and short the overvalued one, anticipating that the prices will converge. This strategy relies heavily on statistical analysis, such as correlation and cointegration, to identify suitable pairs.

Other options do not accurately capture the essence of pairs trading. The strategy does not focus exclusively on one sector or individual stock performance, nor is it limited to technological stocks. Instead, it can be applied across various sectors as long as suitable pairs of securities can be identified. Therefore, the characteristic of taking one long and one short position in related securities is what makes this trading strategy distinct and effective.