When to Enter and Exit Pairs Trades: Z-Score Thresholds Explained
Quick Answer
Enter trades when z-score reaches ±2.0 (standard threshold) or±2.5 (conservative, fewer but higher-quality signals). Exit trades when z-score returns to 0 (mean reversion complete). Set stop losses at±3.0 to limit losses if the relationship breaks down. More aggressive traders use ±1.5 for entry (more opportunities, lower quality), while conservative traders wait for ±2.5 (fewer but stronger signals).
Entry Thresholds: When to Open a Position
Aggressive: Z-Score ±1.5
Entering at ±1.5 gives you more trading opportunities but lower profit per trade:
✓ Pros
- • More trading opportunities (15-25 per year)
- • Faster entry, less waiting
- • Good for active traders
✗ Cons
- • Lower profit per trade
- • More false signals
- • Higher transaction costs
Best for: Experienced traders with low transaction costs and high capital
Standard: Z-Score ±2.0 ⭐
The most commonly used threshold, balancing opportunity with quality:
✓ Pros
- • Good balance of opportunities (10-15 per year)
- • Strong statistical significance
- • Higher profit per trade
- • Works for most traders
⚠️ Considerations
- • Requires patience
- • May miss some opportunities
Best for: Most traders. This is Pair Parade's default recommendation.
Conservative: Z-Score ±2.5
Waiting for ±2.5 gives fewer but higher-quality signals:
✓ Pros
- • Highest profit per trade
- • Very strong signals
- • Lower false signal rate
- • Better risk/reward ratio
✗ Cons
- • Fewer opportunities (5-10 per year)
- • Requires more patience
- • May miss some profitable trades
Best for: Conservative traders, those with high transaction costs, or part-time traders
Exit Strategies: When to Close a Position
Primary Exit: Z-Score Returns to 0
The most common exit strategy is to close when z-score returns to 0 (the mean):
Example:
- • Enter at z-score = +2.0 (spread is 2σ above mean)
- • Wait for mean reversion
- • Exit at z-score = 0 (spread returned to mean)
- • Profit captured
✓ Why this works: Z-score of 0 means the price relationship has normalized. Further profit is unlikely, and holding longer increases risk of reversal.
Early Exit: Z-Score ±0.5
Some traders exit early to lock in profits and reduce risk:
Example:
- • Enter at z-score = +2.0
- • Exit at z-score = +0.5 (early exit)
- • Captures 75% of potential profit
- • Reduces risk of reversal
💡 Use when: You want to reduce risk, lock in profits quickly, or the pair has shown tendency to reverse before reaching 0.
Stop Loss: Z-Score ±3.0
Always set a stop loss to limit losses if the relationship breaks down:
Example:
- • Enter at z-score = +2.0
- • Set stop loss at z-score = +3.0
- • If spread widens to +3.0, relationship may have broken
- • Exit immediately to limit loss
⚠️ Critical: Never trade without a stop loss. Pairs can permanently decouple, and z-score ±3.0 often indicates the relationship has broken down.
Visual Example: Entry and Exit Points
This chart shows z-score over time with entry and exit points marked:
🟢 Entry Signal
Z-Score crosses ±2.0
Action: Open position
⚪ Exit Signal
Z-Score returns to 0
Action: Close position
🔴 Stop Loss
Z-Score reaches ±3.0
Action: Exit immediately
Complete Trade Example
Trade: JPM / BAC
Day 1: Entry Signal
- • Z-score reaches +2.1 (JPM expensive relative to BAC)
- • Action: Short JPM $3,000, Long BAC $3,000
- • Set stop loss at z-score +3.0
- • Target exit: z-score 0
Day 5: Position Moving Well
- • Z-score now at +1.2 (spread narrowing)
- • Unrealized profit: ~$180 (3% on $6,000 position)
- • Continue holding toward target (z-score 0)
Day 12: Exit Signal
- • Z-score reaches 0.1 (essentially at mean)
- • Action: Close both positions
- • Realized profit: $240 (4% on $6,000 position)
- • Trade duration: 12 days
✓ Result: Successful mean reversion trade. Entered at extreme deviation (+2.1), exited at mean (0), captured the full reversion profit.
Choosing Your Thresholds
| Trading Style | Entry | Exit | Stop Loss |
|---|---|---|---|
| Aggressive | ±1.5 | 0 or ±0.5 | ±2.5 |
| Standard ⭐ | ±2.0 | 0 | ±3.0 |
| Conservative | ±2.5 | 0 or ±0.3 | ±3.5 |
Get Real-Time Entry & Exit Signals with Pair Parade
Don't manually calculate z-scores or watch charts all day. Pair Parade shows you live z-scores and sends alerts when entry/exit thresholds are hit, so you never miss an opportunity.
✓ Live Z-Scores
Updated every trading hour
✓ Entry Alerts
Get notified at your threshold
✓ Exit Signals
Know when to close positions
Frequently Asked Questions
Should I use the same threshold for all pairs?
Not necessarily. More volatile pairs (tech stocks) may require ±2.5 for entry, while stable pairs (banking) can use ±2.0. Test different thresholds with historical data to see what works best for each pair. Pair Parade can help you identify optimal thresholds per pair.
What if z-score never reaches my entry threshold?
Patience is key. Good pairs may only hit ±2.0 a few times per year. If you're not seeing opportunities, either: (1) Lower your threshold slightly (to ±1.8), (2) Add more pairs to your watchlist, or (3) Wait—quality signals are worth waiting for.
Can I exit before z-score reaches 0?
Yes, many traders exit at ±0.5 to lock in profits and reduce risk. This captures most of the profit (75-80%) while reducing exposure. This is especially useful if the pair has shown tendency to reverse before reaching 0, or if you want to free up capital for other opportunities.
How often should I check z-scores?
For active trading, check once daily after market close. For more active management, check 2-3 times per day. Pair Parade updates z-scores every hour during market hours, so you can set alerts and don't need to constantly monitor.