Uploaded February 2024 | Updated September 2026, 2 weeks ago

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Does using stops in pair trading kill profitability? We know that using stops when you are modelling or backtesting something really kills the profitability of a system. However, stops are a necessity in the real world to avoid blowing up an account. So how do we do it? That's why it is important to give stops enough legroom for the markets to breath. When we are pair trading, things are a little different. We are trading one instrument another in the same industry and speculating that one is going to outperform another. Let's look at the risk management side of it. How will you react if the pairs trade goes sharply against you? Using stops in pairs can kill your profitability because you're trading against the reason you are taking the trade. So how do you manage the risk?

Stops in pair trading can impact profitability significantly, as they might lead to stopping out of potentially profitable trades.
While stops are necessary for risk management in real-world trading to prevent account blow-ups, they can hinder profitability in pair trading.
Pair trading involves trading one instrument against another in the same sector or market, focusing on price divergences and convergences.
Mark shares an example of a successful pair trader who rarely used stops but instead added to positions as the trade moved against him, relying on mean reversion.
The strategy involves adding layers to the position as the trade progresses, scaling out as the pair reverts to its mean.
While this approach can be profitable, it requires careful capitalization, risk management, and a deep understanding of market dynamics, making it unsuitable for inexperienced traders reliant on stops for risk control.

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