Pair Trading is a very popular market neutral strategy which takes out volatility from the market where one exploits the trading pattern between two similar shares in an attempt to generate a low-risk profit. Without taking a view of the overall direction of the market Trader buys an under priced security and simultaneously sells an overpriced security where he finds a pair of securities whose prices moves together or is highly correlated. This is most often seen in shares of companies from the same sector; for example, direct competitors such as SBIN and ICICIBANK.
When prices diverge, he buys an under priced stock and simultaneously sells overpriced stock. Traders profit if prices converge, but lose money if prices diverge further. In this way, a trader bets on the relationship between two highly correlated stocks and not on the stock direction (up or down) of the market.
Apart from placing a short and a long position on the shares, variations on the basic concept of pairs trading may also be implemented in a variety of ways, including trading from a fundamental analysis perspective (e.g. placing a short position on a share trading at an above average PE to the benchmark and placing a long position on a rival trading below the average PE benchmark). Another variation involves going short on an index and going long on a stock that is expected to outperform that index, or going long on an index and short on a stock that is part of the index but expected to decline.