In a pairs trading strategy, what action is taken when the price spread between two stocks widens?

In a pairs trading strategy, the focus is on the relative performance of two correlated stocks. The foundational principle behind this strategy is to profit from the price spread between the two stocks. When the price spread widens, it suggests that the two stocks are moving apart from their historical price relationship, creating an opportunity for analysts who believe the relationship will revert to its mean.

Selling short the best-performing stock when the spread widens is based on the assumption that the stock is now overpriced relative to the other. This creates a situation where the trader expects the higher-priced stock to decrease in value, while the lower-priced stock is expected to increase or at least not decrease as much. Thus, by short selling the best performer, the trader aligns with the expectation that the price spread will narrow in the future.

This action is taken because the pairs trading strategy operates under the principle of market neutral positions—simultaneously shorting one stock and taking a long position in the other. However, in this specific scenario, the focus is on the broader strategy where a short position is established in response to the widening spread.