A Pairs Trade refers to an equity trading strategy in which two stocks in the same sector are simultaneously bought and sold.
The strategy is essentially an arbitrage strategy in which the trader or hedge fund goes long an underpriced stock and at the same time shorts an overpriced stock in the same sector.
An example would be if an equities trader discovered that the P/E (an indication of the expensiveness of a stock) of United Parcel Service (UPS – NYSE) was 50, yet the P/E of FedEx (FDX – NYSE) was 10. Since the thought is that the two companies are in the same industry sector (small package delivery) the thinking is that the profitability of the two companies should be close to the same, which would lead to the same P/E. Since they are not, the trader would then assume that the high P/E stock would come down in value and the low P/E stock would rise in value and the two would essentially converge somewhere in the middle. With the Pairs Trade strategy, the trader would short the high P/E stock and go long the low P/E stock. The combined position would gain as the two converged in value and P/Es.