Pairs trading can come in many formats. It can also be used among all the investing products that are available. It used to be that pairs trading was used more for just stocks, but now you can find pairs trading approaches on everything from options, to futures, even futures options. Let's talk about the concept and then see if it's right for you.
For starters, this is usually used by the short term traders. A pairs trade is simply a trade in one product followed by an opposite trade in a related or correlated product. For example, if you were to buy Home Depot (NYSE: HD), and subsequently short sell Lowe's Home Improvement (NYSE: LOW). The idea is that these stocks are direct competitors of one another. If they both head higher, then as long as Home Depot gains more, you have a net gain. If they both sell off lower, then as long as Lowe's sells off more then you still have a net gain.
So why would one do something like this? Well, in one word, Risk! The trader is looking to reduce risk in the combined position and is willing to sacrifice some gains for that luxury. Now, there is a chance that Home Depot goes higher temporarily while Lowe's drops, in this case there could be a double profit.
In the options world this is becoming more and more popular. While you could buy a call on Home Depot, you could also sell a call spread on Lowe's. This would serve two purposes. The first is just like the stock trade, you are reducing your risk on the long position. The second benefit is that the credit from the Lowe's call spread will reduce your cost on the Home Depot long call. So when using options and pairs trading there may even be a bigger advantage.
So these are just a few examples. You can get very complex with pairs trades but now you know the general reasons why they might be used. Play around with the idea and see where it takes you. Happy Trading!