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Relative value
Which relationship between two prices is pairs trading betting on?
Pairs trading
What it bets
After the spread between two related prices leaves its recent normal level, it will come back to that level.
How the rule is written
Write the spread as A minus a hedge ratio times B. When the spread is far above its own recent mean, short the spread. When it is far below, go long the spread. Exit near the mean. The hedge ratio and the mean are both estimates. A correlation is not enough. The spread itself has to be able to come back. The shorter the estimation window gets, and the more tightly it is tuned to the past, the easier it is to treat noise as a relationship.
When it fails
The relationship breaks. The spread can travel a long way and not come back. After the hedge, the two legs become one directional exposure.
Do not confuse it with
Statistical arbitrage takes the same idea to a basket of residuals, or to many pairs. A pair handles only two markets. The two legs of a calendar spread are different expiries of the same underlying, not two different coins.