Most traders obsess over direction: “Will gold rally?” “Is tech topping?” “Is crude oversold?”
But the most resilient strategies inside hedge funds don’t care about direction at all. They focus on something far more stable:
How assets behave relative to each other.
These strategies — pairs trading, spread arbitrage, relative value — don’t ask whether a market is bullish or bearish. They ask a behavioural question:
“Has the relationship between these assets moved too far from normal?”
It’s a philosophy shift. Instead of betting on what an asset will do, you monetise what two assets should be doing together.
This is not opinion. It’s structure.
Not belief. Behaviour.
Why Relationships Matter More Than Price
Prices move for a million reasons — monetary policy, positioning, geopolitics, sentiment, liquidity. But relationships? They tend to move for one reason:
Structural linkage.
When two assets share an economic link, a production chain, a sector driver, or a hedging mechanism, their behaviour forms a repeatable profile. That profile can stretch and snap back, like a rubber band. Relative value traders monetise the stretch, not the direction.
Visual: Relationship vs Direction
Directional Trader:
“Is Asset A going up or down?”
Relative Value Trader:
“Is A moving too far away from B?”
The second question is both narrower and more statistically robust.
The Structural Drivers Behind Pairs & Spreads
Why do certain assets maintain relationships? Four behavioural forces:
1) Economic Linkage
Example:
- Brent vs. WTI crude oil
Both respond to global oil demand, refinery spreads, transport dynamics.
2) Production/Cost Chain
Example:
- Iron ore vs. steel
- Corn vs. ethanol
If steel producers face rising input costs, steel prices adjust. The chain links behaviour.
3) Regulatory or Index Exposure
Example:
- Bank stocks vs. bond yields
Rates affect net interest margins — a direct structural linkage.
4) Arbitrage Capital
Large funds enforce pricing fairness because inefficiency = profit.
Ironically, the existence of arbitrageurs helps maintain the relationships they trade.
How Pairs Traders Think: A Practical View
Relative value trading hinges on three behaviours:
- Assets move together due to structural forces
- Short-term dislocations push them apart
- Reversion occurs as behaviour normalises
It’s not about predicting the future. It’s about quantifying what “normal” looks like and trading deviations.
Visual: Mean Reversion of a Spread
Spread (Asset A – Asset B)
↑ Temporary Divergence
|
+2 | *
| * *
+1 | * *
| ** **
0 |*** *** Normal Zone
|
-1 | ** **
| * *
-2 | * *
|
Time —–>
Strategy Focus: Trade the extremes, not the direction of either asset.
The trader does not need Asset A or B to move up or down —
only for the relationship between them to revert.
Behaviour-Based Trading, Not Forecasting
Pairs and spreads work because they monetise how traders behave under stress and expectation.
When panic hits, correlations spike — relationships tighten.
When calm returns, idiosyncratic moves surface — relationships loosen.
Relative value traders don’t forecast greed or fear. They monetise the cycle between cohesion and divergence.
In other words:
They trade the behaviour of markets, not the direction of markets.
Visual Analogy: Two Dogs on One Leash
Picture a person walking two energetic dogs.
Sometimes one dog runs ahead, sometimes the other lags.
But neither can wander too far — the leash pulls them back together.
DOG A (Stocks) 🐕
DOG B (Stocks) 🐕
LEASH (Structural Link) ————
The relative value trader is not choosing which dog will be faster.
They are trading the stretch of the leash.
When Relationships Break (And Why It Matters)
Sometimes the “leash” snaps — and spreads diverge permanently.
This typically happens due to structural change, not trading noise:
- A merger, spin-off, supply shock, or new regulation
- A change in risk regime (e.g., negative rates altering bank-stock behaviour)
- A shift in demand drivers (e.g., EVs changing oil-equity linkage)
Great spread traders aren’t just statisticians. They are macro detectives, asking:
“Is this dislocation temporary or structural?”
The future of spread trading will be won by those who identify behavioural vs structural shifts — not those who blindly trust historical correlation.
Conclusion: Trading Relationships, Not Stories
Pairs and spread arbitrage represent a mature style of trading.
They avoid prediction, minimise ego, and monetise the fabric of pricing, not the headlines around it.
The trader doesn’t need to know whether the market will rise.
They only need to know whether the relationship between two prices is stretched beyond normal behaviour.
In a world full of forecasts and opinions, the most consistent edge is not having a view. It is recognising that markets are built on relationships — and that those relationships, like rubber bands, can stretch only so far before snapping back.
Alpha is not in the asset. It’s in the connection between assets.
Sources
- BIS (2023), “Relative Value Strategies and Market Structure.”
- AQR (2021), “The Science of Pairs Trading and Behavioral Convergence.”
- JP Morgan Markets (2024), “Spread Dynamics in Commodity and Equity Markets.”
- CFA Institute (2022), “Economic Linkages and Arbitrage Efficiency.”