“The strategy monitors performance of two historically correlated securities. When the correlation between the two securities temporarily weakens, i.e. one stock moves up while the other moves down, the pairs trade would be to short the outperforming stock and to long the underperforming one, betting that the “spread” between the two would eventually converge. The divergence within a pair can be caused by temporary supply/demand changes, large buy/sell orders for one security, reaction for important news about one of the companies, and so on.”
… it does not have to be separate items like stocks vs FX, it could be two stocks or two fx currencies etc.
“Trading pairs is not a risk-free strategy. The difficulty comes when prices of the two securities begin to drift apart, i.e. the spread begins to trend instead of reverting back to the original mean. Dealing with such adverse situations requires strict risk management rules, which have the trader exit an unprofitable trade as soon as the original setup—a bet for reversion to the mean—has been invalidated”
However, such opportunities are usually arbitraged away very quickly.
“A theory suggesting that prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry.”
A two period RSI qualifies as a mean reversion strategy. It seems fairly easy to implement and perhaps can be useful in sideways markets. Something to look into: http://stockcharts.com/help/doku.php?id=chart_school:trading_strategies:rsi2
Other Points of interest
– RAFF Regression
– Every trend is different. You need to adjust your stop loss/take profit limits based on the current trend.