Technical analysts have a quiver of techniques to use for investing. They can go long, short, or even be market neutral with options. One of the most popular uses of technical analysis is in the tactic known as pair trading. Pair trading is also known as statistical arbitrage.

It doesn’t use fundamental analysis at all; as it relies strictly on price.  In fact, pair trading doesn’t even use volume as an indicator.

The only indicator is how two or more stocks price relates to each other. Pair trading is the buying or selling of a pair of stocks based on their connection with each other.  From time to time the stock price of companies in the same sector or type of business follows each other very closely.

On occasion these stocks don’t even have to be related to be a strong pair trading pair.

For some unknown reason, the stocks have historically followed each other despite their being no apparent reasoning.

A pair trader observes this connection between two stocks and buys or sells whenever the association gets out of sync having the awareness that the historic correlation will likely continue. Is it a fool proof method? No way! But it does provide another tactic in your investing tool box. It is easier to understand this concept with an illustration.  The following chart shows the relationship between Coca Cola (NYSE:KO) and Pepsi Co (NYSE:PEP),perhaps the most popular stock pair for statistical arbitrage. 

Observe how closely the two stocks follow each other until near the end of May, 2013.

At this time, Pepsi falls out of synch with Coca Cola, dropping as Coca Cola stays steady and starts to rise. Pair traders would purchase Pepsi stock as soon as the divergence is recognized. As you can see, the pair quickly moved back into synch, providing profits for pair traders.

There are substantial risks involved when pair trading. For example, history doesn’t always repeat.  Not to mention the fact that both stocks can do the opposite of what is expected creating much larger losses than if it was just one stock at a time. However, when executed carefully and properly, pair trading can open up an entire new way to profit for savvy investors.