To understand pairs trading, let’s first start with an example.

At Mario’s apple stand, he sells two rows of red apples, each with a price of $1.00 each. The price of both apples have been the same historically and this relationship makes sense as they both represent the same thing, a red apple. However, one day the apples on the right of the stand increased to a price of $1.05, but the apples on the left remained fixed at $1.00. Spotting this anomaly, Sam, the apple trader, decides to make a trade on the assumption that the price of the apple on the right is overvalued to the one on the left, and the relationship will revert to the one seen historically.

To do this, they first understand the risk of the apples continuing to rise in price. So, they buy the apples on the left and short sell (bet against) the apples on the right. If the price of the apples increase, their loss will be limited as they will lose money on the right-side apples, but gain money on the left-side apples, and vice versa if the price of both go down.

Sam’s prediction was right! The price of the apples on the right went back to the historical average of $1.00, and the price of those on the left remained stable at $1.00. From this trade, their profit is $0.05 as they made money from their short position going from $1.05 to $1.00 and their long position staying flat.

But why did this opportunity exist? Like all markets, inefficiencies happen and they usually correct quickly. In this case, perhaps Mario raised the price to slow sales because of perceived fears of an apple shortage, perhaps he simply made a typo when posting that day’s prices, the reasons for market inefficiencies are infinitely vast and can vary in each instance.

Opportunities like this also exist in markets and can be especially profitable in the case of dual class arbitrage. Dual class arbitrage involves taking a pairs trade like in the earlier example, but with stocks that have two classes.

Taking the QGI Google Dual Class Arbitrage Index for example, the index tracks the difference in returns of Alphabet Inc.’s Class C (“GOOG”) and Class A (“GOOGL”) shares. The fundamental difference between these two securities is that GOOGL shares have voting rights, while GOOG shares do not. Because of this, GOOGL shares may trade at a slight nominal premium (e.g., GOOGL trading for $97, GOOG trading for $96.50).

While this slight premium may justifiably exist, there exists arbitrage opportunities when relative premiums/discounts exist(e.g. GOOG increasing by 5%, GOOGL only increasing by 4%). As shown below, the intraday performance of both securities show a near perfect correlation, but when the difference of returns increases (the “spread”), a trade opportunity exists in buying the under-performing shares and selling short the over-performing shares.

Over time, the average spread of the pair is very close 0, so when it increases, a trader can bet on it reverting to the mean. Here’s what the index looks like in action:

As pictured, when the spread widened, a trader would enter into a pairs trade (long the underperforming shares, short the overperforming shares) and they would profit when the spread fell back down to the mean of 0.

See how this index performed in recent times: QGI Google Dual Class Arbitrage Index