Pairs trading

Checked October 2026

The distance method pairs each stock with the one whose price path is closest, then trades the pair when they diverge. Gatev, Goetzmann and Rouwenhorst published it in the Review of Financial Studies in 2006. Backtoast could not run it, because the two stocks have to be one trade.

Backtoast

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Pairs trading

Each month the paper takes stocks that traded every day of the past year, scales their prices to start at 1, and pairs each stock with the one whose path stayed closest, keeping the 20 closest pairs. Over the next six months, a gap of more than two standard deviations of their usual gap opens the trade, $1 long the lower and $1 short the higher, and a crossing back closes it.

Backtoast runs rules on one symbol at a time, so it can't search every stock for its closest partner or hold two stocks as one trade.

It couldn't run for the same reason as perpetual versus spot, which also needs a long and a short held as one trade.

When it works

Pairs trading works when the two stocks share a business, such as two banks or two oil producers, so a gap between them tends to close, and it loses when a pair splits for good, after a takeover or a big change at one company. Traders use it because it's long one stock and short the other, so the market's direction mostly cancels out, and a 2010 study by Do and Faff found it did especially well in the bear markets of 2000 to 2002 and 2007 to 2009. Picking pairs from the same industry is the usual refinement.

Origins

Gatev, Goetzmann and Rouwenhorst reported up to 11% a year above cash for the top pairs from 1962 to 2002.

Backtoast did not run this one.