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Suppose I want to build a pairs trading strategy. Theory says that we can create a zero-investment portfolio by going long stock A and short-selling stock B, given a certain hedge ratio. My question is the implementation of this in the real world.

My intuition:

We borrow stock B by entering a stock reverse repo. We sell stock B in the market at time $t=0$ and with the money from the sale we buy the stock A. When the spread between the A and B is close to zero, we sell the stock A and buy the stock B. We return stock B to the custody plus the repo rate. (For brevity hedge ratio is not taken into account).

Is this correct?

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You pretty much have this correct. You don’t have to have the spread equal to zero to unwind the trade. All you would care is that the stock you bought (stock A) outperform the stock you shorted (stock B) on a dollar basis in order for this to be a winning trade. In real life you would still need some capital in the trade due to margin requirements on the short position. Also you would need to determine your hedge ratio that should take into account whether you are going to be dollar or market neutral (depending on how you define this neutrality.)

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  • $\begingroup$ I read that short sale margin is 150%. 100% comes from the short position and 50% additional margin. To put it simply, I just need 50% of the position as margin as the 100% is covered by the short. Correct? $\endgroup$ – Bougias A. Jan 15 at 7:28
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    $\begingroup$ But you will be using the proceeds from your short position to acquire stock A. If your broker is willing to accept the value of that stock as collateral, then you would be correct. This varies by dealer and you should check with your dealer on what is acceptable collateral for margin. The base is set by the exchange and Reg T requires 50%. For institutional accounts this may be different depending on the prime brokerage requirements. $\endgroup$ – AlRacoon Jan 15 at 14:37

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