Pair trading is a market-neutral approach: instead of betting on whether a stock will rise or fall, a trader bets on how two related stocks will move relative to each other. When the usual relationship stretches unusually far, the trader buys the one that looks relatively cheap and sells the one that looks relatively expensive, expecting the gap to narrow.
This article explains how the trade works in India, where futures are usually needed for the short side, works through an example, covers how pairs are chosen, and sets out why many such trades fail.
The basic idea
Some stocks tend to move together because they share drivers: two large private banks, two IT services companies, two cement makers. Their prices rise and fall with the same economic forces, so the relationship between them is relatively stable.
Traders often measure that relationship as a price ratio: stock A's price divided by stock B's. If the ratio has historically hovered around a level, a large move away from that level may be temporary.
When the ratio is unusually high, A has outperformed B; the trader sells A and buys B. When it is unusually low, the trader does the opposite. If the ratio returns towards its usual level, the trade profits regardless of whether the market as a whole rose or fell.
Why futures are used in India
The trade needs one long position and one short position, held for days or weeks. In the Indian cash market, retail investors can generally sell shares they do not own only within the same day. Holding a short position overnight requires futures (or, less directly, options).
So pair trades are usually built with stock futures: buy the future of the relatively cheap stock and sell the future of the relatively expensive one. This limits pair trading to stocks with futures contracts.
Matching values. The two legs should have roughly equal rupee exposure, so that a general market move affects both similarly. Because lot sizes differ, exact matching is often impossible; the leftover mismatch is a directional exposure the trader must accept or reduce.
Margins. Both legs require margin, and exchanges may offer some benefit for offsetting positions, but do not assume it. Daily mark-to-market applies to both.
A worked example
Illustrative figures. Over the past year, the ratio of stock A to stock B has mostly stayed between 1.9 and 2.1, averaging about 2.0. Today, A trades at 1,100 and B at 500: a ratio of 2.2, well above its usual range.
The trader sells A futures and buys B futures with roughly equal value, say about 5.5 lakh each: 500 shares of A (5.5 lakh) and 1,100 shares of B (5.5 lakh), assuming lot sizes allow it.
Scenario 1: the ratio narrows to 2.1 with the market up. A rises to 1,155, B to 550. A's short loses 55 × 500 = 27,500. B's long gains 50 × 1,100 = 55,000. Net: about 27,500 before costs.
Scenario 2: the ratio narrows to 2.1 with the market down. A falls to 1,029, B to 490. A's short gains 71 × 500 = 35,500. B's long loses 10 × 1,100 = 11,000. Net: about 24,500 before costs.
Scenario 3: the ratio widens to 2.4. A at 1,200, B at 500. A's short loses 100 × 500 = 50,000. B's long is flat. Net: a loss of 50,000.
The result depends on the ratio, not the market direction, which is both the strength and the risk of the approach.
How traders choose pairs and entry points
A genuine economic link. Same industry, similar size, similar business mix. A statistical relationship between unrelated companies is likely to be coincidence.
A stable history. Traders look at how the ratio has behaved over a long period. Some use statistical tests for whether the two prices tend to come back together, a property called cointegration, which is stronger than simple correlation.
Measuring how stretched the ratio is. A common approach is the z-score: how many standard deviations the ratio is from its recent average. Entries might be considered at two standard deviations, with exits near the average.
Checking why the gap opened. Before entering, read the news. If one company reported a major problem, the ratio may have moved for a lasting reason.
Defining the exit in advance, including a stop if the ratio keeps moving against the position and a time limit if it does not revert.
Why pair trades fail
Relationships break. A merger, a regulatory change, a management failure or a new business line can change a company's prospects permanently. The ratio then moves to a new level and never comes back. This is the main risk, and it is impossible to rule out in advance.
Past stability is no promise. A ratio that looked stable for three years can drift for the next three.
Costs on four transactions. Brokerage, statutory charges and spreads on both legs, at entry and exit, plus rollovers if the trade runs past expiry, eat into small expected gains.
Ban periods and corporate actions. One stock entering an F&O ban can prevent adding to or adjusting that leg. Dividends, splits and other events need careful handling.
Overfitting. Searching hundreds of pairs for ones that looked good historically finds many that worked by chance.
Hidden leverage. Futures on both legs can mean a large total exposure relative to capital. Size for the scenario where the ratio moves well beyond its historical range.
An account for stock futures
Check margins for combined positions and track both legs together before committing. Free to open
Figures are illustrations; lot sizes, margins and charges are set by the exchanges, SEBI and your broker and change from time to time. This is educational material, not advice, and no stock or position is recommended. We run no tips group and no signal service, we manage nobody's money, and no return is promised. Derivatives can lose more than the amount blocked against them.
Disclosure: the account-opening link on this page is under Atul Shrivastava's Zerodha Authorised Person registration (NSE AP Reg: AP2516003481; Zerodha Broking Ltd. SEBI Reg: INZ000031633) and earns a revenue share. TheFinBaba is not a SEBI-registered Investment Adviser — this content is educational, not investment advice.
Frequently Asked Questions
What is pair trading?
Buying one stock and selling a related one when their usual price relationship stretches unusually far, aiming to profit if the gap narrows, regardless of the overall market direction.
How is pair trading done in India?
Usually with stock futures, because retail investors generally cannot hold short positions in the cash market overnight. One future is bought and the other sold with similar rupee values.
How do traders choose pairs?
They look for stocks with a genuine economic link and a stable historical price ratio, sometimes testing for cointegration, and measure how stretched the ratio is with a z-score.
Is pair trading risk-free because it is market-neutral?
No. The main risk is that the relationship breaks permanently, so the ratio never returns. Costs, ban periods and leverage add further risk.
What is the difference between correlation and cointegration?
Correlation measures whether prices move together day to day. Cointegration indicates whether the gap between them tends to return to a stable level, which is what pair trading relies on.
Related Reading
- Why losing legs get held too long
- Futures as a hedge
- Daily settlement on both legs
- Ban periods that freeze a leg
- Short selling rules for retail
- When a relationship stops holding
Disclaimer: TheFinBaba provides educational content only - this is not investment advice. Trading involves risk of loss.
