Trade Like a Hedge Fund: Using Pairs Trading
The important thing here is to find the point where the pair is starting to converge again. To do this, you could smooth the price data from each security and look at the trend changes, or you could assume that the pairs will converge once the prices diverge (say) 2.5 standard deviations from the mean.
The next step is to place a long and a short trade. You should preferably use derivatives to do this because this enhances your leverage. You will need to place stop losses for both trades in case the pair keeps diverging. You can determine the stop loss by finding the point where statistically the pair has gone outside of the normal divergence. Again, you will need to use standard deviations to measure this.
Once the pair converges again, you will be able to close out the trades for a profit.
This article has outlined some of the potential of a trading technique used by hedge funds. They have their own proprietary variations to this now, but it can be a sound approach that maximises your profit opportunity whilst “hedging” out market risk. This is my favourite book on the subject: Pairs Trading Quantitative Methods and Analysis by Ganapathy Vidyamurthy
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