How to Answer “Explain a long/short pair trade and how you would construct one.” in Hedge Funds Interviews
In hedge fund interview prep, “Explain a long/short pair trade and how you would construct one” is a common advanced prompt because it tests whether you can turn a view into a risk-controlled, implementable trade.
A strong answer defines a long short pair trade in one sentence, then explains how you’d choose the two legs, set the hedge ratio, size the position, and manage the spread with clear catalysts and exits—so returns are driven by relative performance rather than market direction.
What Hedge Funds Test in Pair Trading Strategies
Interviewers are assessing whether you understand what a pair trade is actually hedging and what risks remain. They want you to articulate the P&L driver (spread widening/tightening), specify the intended neutrality (dollar/beta/sector/vol), and avoid hand-wavy “they’re correlated” explanations.
They’re also testing real-world judgement on pair trading strategies: security selection (true substitutes vs lookalikes), hedge ratio choice (regression/factor/fundamental), and implementation details that matter at a hedge fund (borrow, liquidity, corporate actions, crowding).
Finally, it’s a communication test typical of hedge fund analyst questions: can you present a repeatable construction process, state a clear thesis + catalyst + horizon, and outline risk controls in 2–4 minutes like you would in an investment analysis discussion.
Long/Short Equity Trade Construction Framework
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Step 1: Define the trade and the return driver (spread, not direction)
Start with a precise definition. A long/short pair trade is a relative-value position where you go long one security and short a closely related one to isolate idiosyncratic mispricing; the intended return comes from the spread between the two legs moving in your favour.
Then state what “hedged” means in your setup. You might target dollar neutrality (remove simple directional exposure), beta neutrality to the market or sector (reduce factor shocks), or volatility neutrality (avoid one leg dominating risk). Be explicit that a pair trade is not “risk-free”: you’re exchanging market risk for spread/basis risk, event risk, and model/parameter risk.
Close by framing when it’s appropriate: when the two names share key risk factors and you have a clear reason the relative pricing should change (mean reversion with a rationale, or a catalyst-driven divergence/convergence).
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Step 2: Choose the two legs like an analyst (substitutes + fundamental edge)
Describe a disciplined selection process. Start by screening for comparability: same sub-industry, similar revenue drivers/geography, comparable margin structure and balance sheet, and similar factor exposures (size, value/growth, momentum). Correlation can be a filter, but not the thesis.
Next, form the relative view: what is mispriced and why? Use valuation and fundamentals together (e.g., EV/EBITDA vs growth quality, FCF yield vs reinvestment needs, leverage/coverage vs cyclicality). Good interview answers show a specific edge—e.g., one company’s margins are temporarily depressed but improving, while the peer is priced for peak margins that are vulnerable.
Include implementability checks early: liquidity/ADV, borrow availability and cost for the short, short interest/crowding, and whether either leg has a binary corporate action risk that could dominate the spread.
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Step 3: Set the hedge ratio and sizing (neutrality choice + risk budget)
Explain how you’d size the legs so the trade expresses your thesis rather than accidental factor bets. First pick the neutrality target consistent with your risk you want to remove: dollar-neutral for basic hedging, beta-neutral if market/sector moves can swamp the spread, and vol-neutral if the two legs have very different realised volatility.
Then outline practical hedge-ratio methods used in long/short equity: (1) regression-based hedge using historical returns to market and sector indices, (2) factor model hedge to neutralise sector/style exposures, and (3) fundamental hedge ratios tied to a key driver (e.g., commodity sensitivity, rates sensitivity, or unit volume exposure).
Finish with risk sizing: cap gross and net exposure, size to expected drawdown (not just conviction), respect liquidity limits (position vs ADV), and avoid concentrating multiple pairs that all share the same hidden factor (a common failure mode in hedge fund portfolios).
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Step 4: Make it a trade: catalyst, monitoring plan, and exits
Turn mechanics into an actionable trade plan. State the thesis in a clean relative format: “Long A because X is underappreciated; short B because Y is overappreciated; I expect the spread to move by Z over T months.”
Add catalysts that can reprice the relative valuation: earnings and guidance, estimate revisions, product launches, regulatory decisions, cost normalisation, index changes, or a comp reset. This is where technical interview prep becomes “desk-ready”: you’re showing you know why the spread should move now, not just “over time.”
Describe what you’d monitor: spread level vs history, factor exposures drift, revisions, news flow, positioning/flows, and borrow changes. Define exits upfront—take-profit on a spread target, a time stop if the catalyst window passes, and a thesis stop if the fundamental relationship changes even if the spread looks statistically ‘cheap’.
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Step 5: Map residual risks and mitigants (what breaks the pair)
Close with a concise risk map that shows mature judgement. Key risks include basis risk (they’re not true substitutes), factor drift (one leg’s sensitivity changes), event risk (M&A, litigation, management change, dividend/special distribution), technical/flow risk (crowding, squeezes), and implementation risk (borrow recalls/cost spikes, liquidity gaps).
Then give realistic mitigants: diversify across multiple pairs and industries, cap single-name exposure, run event filters around known binaries, rebalance to maintain neutrality if exposures drift, and pre-plan actions if borrow costs rise or liquidity deteriorates.
End with one sentence linking back to investment strategies: the goal is a clean relative-value expression where you can explain the P&L driver, the catalyst path, and the bounded residual risks—exactly what hedge fund interviewers want to hear.
Long Short Pair Trade: Model Answer (Analyst-Level)
A long short pair trade is a relative-value position where I buy one stock and short a closely related stock so the P&L is driven mainly by the spread between them rather than the overall market.
To construct one, I first pick two true substitutes—same sub-industry and similar fundamental and factor exposures—then form a specific relative thesis. For example, I might be long Company A because the market is underestimating a margin recovery from pricing and mix, and short Company B because it’s priced for peak growth despite facing the same input costs and slowing demand.
Next I decide what I want to neutralise and set the hedge ratio accordingly. If broad moves could dominate, I’d target market- and sector-beta neutrality using a returns regression, then sanity-check the exposures with a factor model and scale by volatility so one leg doesn’t carry most of the risk. I also check implementation early: liquidity, borrow availability and cost on the short, and any corporate actions that create binary outcomes.
Finally, I make it a trade plan: define the catalyst and horizon (typically earnings/guidance and revisions over 1–3 quarters), set a spread target, and set exits—a take-profit level, a time stop if the catalyst passes, and a thesis stop if the relative fundamentals change. Throughout, I monitor spread behaviour, factor drift, positioning, and borrow, because those are common ways pair trades fail in practice.
- Lead with the spread-based objective before discussing hedge ratio mechanics.
- Distinguish ‘correlation screen’ from the fundamental reason the spread should move.
- State your neutrality choice (dollar/beta/vol/sector) and how you’d estimate it.
- Call out implementation realities (borrow, liquidity, corporate actions) to sound hedge-fund practical.
- Include clear exit rules (target, time stop, thesis stop) to demonstrate risk management.
Common Mistakes in Hedge Fund Analyst Questions
- Saying a pair trade is “two correlated stocks” without naming the spread driver and what is being neutralised.
- Defaulting to 50/50 dollar weights and ignoring beta/vol differences or factor drift.
- Giving a relative thesis with no catalyst, horizon, or measurable spread target.
- Ignoring short mechanics (borrow cost/recall risk, crowding, short squeezes) that can dominate returns.
- Assuming mean reversion is guaranteed and skipping scenarios where correlation breaks due to fundamentals or events.
- Not defining exits, implying you would ‘hold and hope’ through drawdowns.
Follow-Ups in Technical Interview Prep for Pair Trading
How would you pick the hedge ratio in practice?
I’d start with a regression-based hedge to market and sector to target beta neutrality, validate with a factor model, and vol-scale; then I’d stress-test and rebalance if exposures drift.
What does “market-neutral” mean for a pair trade?
It depends on the factor: you can be dollar-neutral, beta-neutral, sector-neutral, or vol-neutral; I’d state the chosen neutrality explicitly and discuss the residual spread and event risks.
What are good sources of edge for pair trading strategies?
Edges usually come from fundamental divergence (quality of growth, margin sustainability, balance-sheet risk) plus a catalyst that forces relative repricing, not from historical correlation alone.
How do you manage a pair trade when the spread moves against you?
I check whether it’s factor-driven noise or thesis break by reviewing news, revisions, factor exposures and positioning; I’ll rebalance to maintain neutrality, but exit on thesis/time stops.
What are the biggest risks on the short leg?
Borrow cost and recall risk, squeezes/crowding, and corporate actions like takeouts; those constraints feed directly into sizing and whether the trade is worth running.
How to Practise Investment Strategies Answers with AceTheRound
- Practise a 3-minute structure for explaining long/short pair trades in interviews: definition → leg selection → hedge ratio → catalyst → risks/exits.
- Prepare one concrete “example of a long short pair trade” from an industry you know well, with a clear mispricing and catalyst, and be ready to defend the hedge ratio choice.
- Rehearse neutrality language (dollar vs beta vs vol) so you can answer follow-ups on long short equity construction without rambling.
- Use AceTheRound to run timed reps and request feedback specifically on: clarity of the spread driver, realism of implementation checks (borrow/liquidity), and whether your exits are decision-useful.
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