Why Pairs Trading Works When Markets Don’t

When markets whiplash from one crisis to another, it’s easy to feel as if you are navigating a storm with no map. The past few months have been one such rollercoaster ride, thanks to global uncertainties—geopolitical tensions, fluctuating commodity prices, and shifting interest rate cycles. 

For the average investor or even a seasoned fund manager, this volatility feels like a gamble, with traditional buy-and-hold strategies taking a beating. Investors, glued to screens, ride on panic, react to headlines, and try to time rebounds. 

But what if they didn’t have to? 

Enter pairs trading—an under-the-radar strategy that could be an investor’s lifeline, turning chaos into opportunity with a disciplined, low-stress approach.

Pairs trading hinges on pairing two similar stocks—say, HCL Infotech and Persistent Systems, or JSW Steel and Tata Steel—and betting on their natural rhythm. These companies, operating in the same sectors, tend to move in tandem over time. 

Occasionally, short-term disruptions cause these otherwise correlated stocks to drift apart. The trick is to spot this temporary divergence and profit when they realign. Unlike high-frequency trading, which demands constant, nerve-wracking attention, pairs trades happen only once in a few weeks or a few months, offering a more relaxed pace that suits most investors.

Trading Process
Here's how it works. First, we check the correlation. Using historical stock price data (daily returns), we confirm a strong correlation—typically above 0.80 over a few weeks or months. We also check for cointegration, which tests if their price difference (ratio rather than the raw spread) stays stable like a rubber band, always snapping back. 

When the spread's z-score—our measure of imbalance, calculated using a rolling period mean and standard deviation—hits extremes (e.g., beyond a threshold of 2+ standard deviations on either side), we act. For instance, if HCL outperforms while Persistent lags, we sell HCL and buy Persistent, expecting them to balance out. 

When the spread returns closer to the mean—say, a z-score of about 0.5—we exit, often yielding excellent profits despite the overall market storm. 

Since we rely on this rolling calculation, a reversal might occasionally result in a loss, but we choose pairs based on a higher win rate—of 70-80%—and consistent profitability rather than chasing the highest gains.

Despite its low-frequency and seemingly low-risk nature, pairs trading is not guesswork. We dodge sector shocks—IT or steel slumps—by pausing during industry shifts to avoid broader market disruptions.  

We usually stay away from trades 3-4 days before and after earnings or significant corporate news to avoid surprises that could widen the spread. We also ensure both stocks are sufficiently liquid, with daily volumes above 100,000 shares, for smooth entries and exits. And we tweak our bets based on "beta," adjusting for market sensitivity to shield against broad crashes, adding a layer of stability.

Proven Results
Pairs trading works effectively because it focuses on the relationship between stocks rather than predicting market direction, creating a natural hedge against unpredictable swings.

Our in-house backtests from June 2012 to March 2025 demonstrate the potential: the HCL-Persistent pair generated impressive returns of 167% from 62 trades (with a 79% win rate) over a total holding period of 1,627 days or four-and-a-half years, translating to a 24.4% annualised return. This includes four significant losses—three hitting our 30% stop-loss and one at 22%. These were not excluded or adjusted—what you see is what you get. 

In practice, we expect to identify relationship divergences earlier through company news and events. 

This strategy particularly shines during market downturns, providing a buffer against volatility without requiring the constant monitoring that high-frequency trading demands.

Critics might argue pairs trading is too complex for retail investors or that past performance doesn't guarantee future results—especially in today's unpredictable markets. 

They're partially correct. It requires precision in calculation as well as execution, demanding solid quantitative expertise and skills. It isn’t for the casual trader or someone chasing meme stocks. 

Another objection could be that frequent trading could erode returns via transaction costs and taxes. But this is a myth—models can be specifically designed to generate fewer trades, reducing transaction costs even if it means accepting lower gross returns. 

The true strength of this approach lies in its independence from broader market trends and its relatively infrequent trading requirements—a valuable quality when headlines are fueling market panic.

Pairs trading isn't a get-rich-quick scheme—it's a disciplined anchor. As markets toss investors around, this strategy provides a stable approach that doesn’t rely on guessing direction or constantly reacting to sentiment. It’s not flashy. It’s not fast. But it works—as long as you stay informed and tweak your models. 

For those with the statistical skills—and the temperament—to pursue it, pairs trading can be a thoughtful, disciplined anchor. In volatile waters, you don’t need to ride the wave. Sometimes, all you need is to balance the boat.  

Suresh Iyer, a seasoned investment banking advisor, guides global conglomerates on South Asia strategy, leveraging expertise in venture capital and acquisitions.
Balachandran Venkataraman, former CFO of Paterson Securities, has four decades of experience across finance, investments, investment banking, and consulting.