Explain pair trading to a layman. What is it, why would you want to do it, and what are the risks? Provide a real life example.
Pair trading is a market neutral bet. Instead of saying the market in general is going higher, you say one investment under/overvalued relative to another, typically similar, investment. The bet is that the spread between the two will widen or narrow depending on how you set it up.
For instance, say I feel GM is going to outperform Ford over the next year. I will buy GM's stock and short Ford's stock. By doing this the market is taken out of the picture, and I make money if the difference between GM's stock and Ford's is greater than it was when I undertook the investment.
Quantitative pair trading (as we are on the quantitative finance forum) is based on cointegration.
Two stocks are said to be cointegrated if they move together, which means that they share the same long term trend.
Precisely: It exists a linear relationship between the price of the 2 stocks so that is mean reverting. (for instance the difference between the 2 is mean reverting). But it can be another relation.
Once you have a mean reverting basket, you can study this mean reversion (average, speed to come back to the mean, etc...) And it exists optimal strategies to trade this basket.
Don't forget that past behavior is not always a good indicator of future behavior. A cointegration relationship can evolve/break. Then:
1/ Think also about the exit/stop loss strategies. 2/ Try to make all your coefficients time varying
"Quantitative Trading", Ernie Chan's book is a good starting point to learn pairs trading.
Pairs trading is simple in concept if you look at it like two lovers. Try to split them apart, and they become sad and want to get back together, they'll do anything to get closer, and as they do, their happiness increases.