In this article we are going to revisit the concept of building a trading strategy backtest based on mean reverting, co-integrated pairs of stocks. So to restate the theory, stocks that are statistically co-integrated move in a way that means when their prices start to diverge by a certain amount (i.e. the spread between the 2 stocks prices increases), we would expect that divergence to
eventually revert back to the mean. In this instance we would look to sell the outperforming stock,and buy the under performing stock in our expectance that the under performing stock would eventually “catch up” with the overpeforming stock and rise in price, or vice versa the overperforming stock would in time suffer from the same downward pressure of the underperforming stock and fall in relative value.
Hence, pairs trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement.