Pairs trading capitalizes on price divergences between correlated assets while reducing directional risk by approximately 80%. This strategy involves betting on spreads between highly correlated markets like SPY and IWM (correlation around 0.8-0.9) or sector-specific stocks like airlines or banking.

To set up a pairs trade: identify correlated assets that have recently diverged, calculate notional values, adjust for implied volatility, and determine the appropriate ratio. For example, when comparing SPY ($630) to IWM ($220), initial math suggests a 3:1 ratio, but after volatility adjustment, the proper ratio becomes closer to 2:1 (50 SPY shares to 100 IWM shares).

Futures contracts offer more efficient pairs trading due to higher leverage and lower capital requirements compared to stocks. This approach increases trading opportunities during low volatility periods.