Markets are full of uncertainty. Prices rise, fall, and swing with global news, company earnings, and investor sentiment. While some traders chase these movements, others prefer to balance their exposure with strategies designed to remove overall market risk. This is where pair trading and other market neutral strategies come in, often used by professional traders and even market neutral funds.
 

Pair trading allows you to profit from the relative performance of two assets, rather than betting on the market as a whole. By taking long and short positions simultaneously on two correlated assets, you can create a balanced setup that benefits from the spread between them rather than overall market moves. In this article, we’ll explore how market-neutral setups work, why traders use them, and how you can practice pair trading step by step.
 

Why traders use market neutral strategies

 

Pair trading in practice: quick overview

 
Pair trading involves selecting two historically correlated assets, such as two stocks in the same sector. If one underperforms while the other outperforms, traders take opposing positions to profit from their convergence back to the mean. This style of trading is a core example of market neutral strategies, designed to reduce market risk by limiting exposure to broad market swings. Many market neutral funds employ similar approaches, focusing on relative performance rather than the direction of the overall market.
 

Market-neutral strategies: objectives and benefits

 

What market neutral strategies aim to achieve

 
The goal of market neutral strategies is to reduce market risk by removing directional exposure. Instead of relying on whether the entire market rises or falls, these strategies seek to generate returns regardless of broader conditions. This is why many market neutral funds and professional traders often adopt long-short strategies, balancing long and short positions to focus on relative performance rather than overall market movements.
 

Market neutral funds and investor use cases

 
Market neutral funds are designed for investors seeking consistent returns with lower volatility and reduced market risk. They appeal to those who want equity exposure without bearing the full brunt of market downturns. By employing market neutral strategies, these funds use long and short positions in balanced ways, allowing investors to capture relative performance between assets while maintaining portfolio stability.
 

Equity market neutral explained

 

How equity market neutral strategies work

 
Equity market neutral strategies aim to reduce market risk by focusing on relative performance rather than overall market direction. This approach involves buying undervalued stocks and shorting overvalued ones within the same sector. For example, a trader or a market neutral fund might go long on a retailer expected to outperform while shorting another with weak earnings. The profit comes from the difference in performance, allowing investors to benefit even if the broader market moves sideways or experiences volatility.
 

Short equity mechanics in long-short strategies

 
Short selling is a key component of market neutral strategies, particularly within equity-focused approaches. By borrowing shares and selling them at current prices, traders aim to buy them back later at lower prices, profiting from declines while managing market risk. Different types of market neutral strategies combine long and short positions in various ways, allowing investors to focus on relative performance instead of overall market direction, which helps reduce exposure to broad market swings.
 

Types of market neutral approaches

 

Sector-neutral approaches

 
Sector-neutral strategies involve balancing long and short positions across an industry. By carefully selecting positions, traders can achieve diversification within the sector, reducing exposure to sector-wide news or events. The goal is to profit from discrepancies in individual stock performance while keeping overall sector risk minimal.
 

Statistical pairs and mean-reversion setups

 
Pair trading often relies on mean reversion, the assumption that prices of related assets will eventually converge. A skilled manager can use statistical analysis to identify pairs that historically move together, highlighting potential discrepancies in pricing. By trading multiple pairs across sectors, the strategy also achieves diversification, reducing reliance on any single asset’s performance.
 

Statistical arbitrage and quantitative techniques

 

Statistical arbitrage: concepts and common models

 
Statistical arbitrage (stat arb) is a data-driven strategy that uses mathematical models to identify mispricings between securities. A skilled manager analyzes historical data to predict relationships and build rules-based trading systems. The goal is to achieve consistent, positive returns by exploiting small discrepancies while limiting exposure to market-wide movements.
 

Using correlation and cointegration for pair selection

 
Correlation measures how closely two assets move together. Cointegration goes a step further, ensuring that while assets may diverge short-term, they remain connected over the long term. A skilled manager uses these tools to select reliable pairs and design trades that achieve consistent, positive returns.
 

Implementing long-short pair trades in the stock market

 

Identifying candidate pairs for pair trading

 
Pairs are often chosen within the same industry to reduce external risks. For example, two banks, two energy companies, or two airlines might make strong candidates for a pair trade. A skilled manager can analyze these pairs to generate trading opportunities that aim for positive returns while minimizing exposure to sector-wide fluctuations.
 

Entry, exit and spread-threshold rules

 
Traders monitor the spread between two assets. When it widens beyond historical norms, they enter the trade: buying the underperformer and shorting the outperformer. A skilled manager can help generate setups designed to capture positive returns as the spread reverts to the mean. Exit rules are triggered when the spread returns to its typical range, locking in gains while minimizing risk.
 

Position sizing and hedging for pair trades

 
Position size matters. To maintain neutrality, positions are often weighted by volatility or market value, ensuring one side doesn’t dominate risk exposure. Applying quantitative methods can help determine the ideal allocation of capital for each leg of the trade, while considering potential future movements.
 

Worked example: a long-short pair trade step-by-step

 

• Identify two correlated stocks, such as Coca-Cola and Pepsi.
• Track their historical price spread and set thresholds for divergence using quantitative analysis.
• If Pepsi underperforms, go long Pepsi and short Coca-Cola in equal weighted positions to balance capital exposure.
• As the spread narrows, close both trades to capture the future profit.
   

Practical checklist for pair trade execution

 

• Confirm historical correlation or cointegration.
• Set clear entry and exit levels.
• Calculate position sizes for neutrality and efficient capital allocation.
• Use stop-loss orders for risk control and potential future market swings.
   

Execution, monitoring and scaling

 

Monitoring divergence, reversion and performance

 
Ongoing monitoring is essential. Traders must watch the spread to see if it widens or narrows, adjusting positions as needed. Using quantitative metrics, they can calculate expected returns and determine when the spread has effectively reverted to zero, signaling it may be time to close or scale the trade.
 

Managing execution risk and short squeezes

 
Execution risk arises if short positions face sudden rallies. Short squeezes can cause losses if the borrowed stock surges. Traders often monitor beta to understand how sensitive a stock is to market movements, aiming to protect returns. Position sizing and stop-losses help ensure that potential losses are limited, ideally bringing net exposure close to zero in volatile situations.
 

Scaling strategies and portfolio construction

 
Pair trading can scale into full market-neutral portfolios. By combining dozens of pairs, traders diversify their relative-value bets, smoothing returns and reducing sensitivity to individual asset swings (beta) across the portfolio. Proper weighting ensures that net market exposure approaches zero, maintaining neutrality while allowing gains from relative movements.
 

Metrics for assessing market neutral funds

 
Investors often evaluate funds using metrics like Sharpe ratio, drawdowns, beta, and consistency of returns rather than headline profits. Keeping net exposure near zero is a key consideration in assessing risk-adjusted performance.
 

Best practices for operating pair trades in the stock market

 

• Use liquid stocks to avoid execution delays.
• Combine statistical models with fundamental analysis.
• Keep a trading journal to refine strategies.
   

Pair trading and other market-neutral setups are not about predicting where the market will go. Instead, they allow traders to profit from relationships between assets while reducing market beta and exposure to broad market swings, keeping net market exposure close to zero.
 

For beginners, pair trading can seem complex, but starting with simple examples and practicing in a demo environment builds confidence. Platforms like 24markets.com provide access to global markets, advanced charting tools, and demo accounts where you can safely test strategies before committing real capital.
 

Market-neutral trading requires discipline, analysis, and patience, but it offers a path toward consistent returns with managed beta and minimal net exposure.