Pairs trading: Answer Guide 2027
Pairs trading buys one stock and shorts a closely related one — betting the spread between them reverts to its historical norm rather than betting on market direction. In a pairs trading interview question, explain the cointegration logic, how trades are triggered, and the key risks.
Pairs Trading Interview Questions: What They Test
The idea: two historically correlated stocks (Coke and Pepsi, say) usually move together; when the spread widens abnormally, go long the laggard and short the leader, expecting convergence. Statistically, practitioners test for cointegration — a stable long-run relationship — rather than mere correlation, since correlations break.
Triggers are typically z-score based: enter when the spread exceeds ~2 standard deviations from its mean, exit at reversion or a stop-loss. The risks are the interview point: relationships break permanently on fundamental news (the "pair" was never a law), short squeezes punish the short leg, and crowded pairs unwind violently when many funds exit together.
How to Answer a Pairs Trading Interview Question
- Define it. "Long one stock, short a related one — a bet on relative convergence, not market direction."
- Explain the statistics. "Cointegration identifies pairs with a stable spread; z-scores trigger entries at abnormal divergences."
- Walk the trade. "Spread at +2 sigma: long the underperformer, short the outperformer, exit on reversion."
- Name the risks. "Fundamental breaks, crowded unwinds, and short-leg squeezes — mean reversion is not a law of nature."
Common Mistakes in Pairs Trading Interview Answers
- Using correlation alone. Correlation measures co-movement, not a stable spread — cointegration is the correct concept.
- Assuming reversion is guaranteed. Structural change kills pairs — always pair the strategy with a stop discipline.
- Ignoring the short leg's cost. Borrow fees and squeeze risk live on the short side — factor them into expected returns.
Pairs trading is the canonical stat-arb example — the convergence bet plus the break-risk caveat is the interview answer.
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FAQ
Q: What is cointegration in pairs trading? A: A statistical property where two price series maintain a stable long-run relationship, so their spread tends to revert to a mean.
Q: How are pairs trading signals generated? A: Typically when the price spread's z-score exceeds a threshold (often ~2), signaling abnormal divergence worth betting against.
Q: What is the biggest risk in pairs trading? A: The relationship breaking permanently on fundamental news — the spread widens instead of reverting.
Q: Is pairs trading market-neutral? A: Approximately — the long and short legs hedge broad market exposure, leaving the relative spread as the return driver.
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