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Posted December 4, 2025 at 11:46 am
The article “A Short Take on Real-World Pairs Trading” was originally posted on Robot Wealth.
In textbooks, one often sees pairs trading algorithms start by regressing prices of Asset A on Asset B to calculate a hedge ratio.
I’ve rarely seen anyone actually do this in the real world.
That’s because it is a very unstable thing – especially for a pair of volatile assets, and especially over a large amount of data.
The basic pairs trading algorithm which you see out in the real world doesn’t attempt to do this. Instead, you do the following (or something like it):
The thinking is the following…
if it reverts, it reverts, however I calculate the hedge ratio – so I’m just going to assign equal risk exposure to each leg and save myself some hassle.
This simple approach tends to work well for equities and similar futures contracts. (i.e. different stock indexes or bonds of different durations).
Where you have two totally different things (you’re spreading JGBs against copper because you’re a maniac, for example… and yes, I did this once upon a time….) then you can still make the simple approaches work by weighting the ratio by something sensible like the ratio of the realised or implied volatility of each leg.
The main lesson from this is that the smartest-seeming thing is often not the best in trading.
In academic land, you often see people calculating hedge ratios using dynamic linear models (Kalman filters, etc), copulas, genetic algorithms, etc. When I started out, I did all of these things as well.
In the real world, where implementation, scalability and profitability are prioritised, the simpler approach tends to win out.
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This material is from Robot Wealth and is being posted with its permission. The views expressed in this material are solely those of the author and/or Robot Wealth and Interactive Brokers is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to buy or sell any security. It should not be construed as research or investment advice or a recommendation to buy, sell or hold any security or commodity. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
Futures are not suitable for all investors. The amount you may lose may be greater than your initial investment. Before trading futures, please read the CFTC Risk Disclosure. A copy and additional information are available at ibkr.com.
Short selling is an advanced trading strategy involving potentially unlimited risks and must be done in a margin account.
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