In a nutshell, here is what pair trading is all about.
You pick 2 trading instruments that you believe will continue to perform on a relative basis in the way they have been. This means you think the stronger one will continue to be stronger, and the weaker one will still be weaker.
A pair trade is a way to neutralize market volatility. As an example, right now the US market is losing money every day. Emerging markets are also losing money everyday. The crucial difference is that emerging markets are losing money faster than US markets.
Since this relationship may very well continue for the near future, here is what you can do (hypothetically, for purposes of discussion and education only):
Go long the US market by buying shares of the S&P 500 exchange traded fund (symbol: SPY). Go short an equal dollar amount of the emerging markets exchange traded fund (symbol: EEM). T Then on days when the US is down 3% but emerging markets are down 5%, you will net the difference in the 2 performances, which in this example is a positive 2%
As you can see this method will neutralize market volatility and allow you to make money based on the difference in relative performance.
Exchange traded funds are an ideal way to play this kind of short to intermediate term trade because they are composites of underlying companies, and you are able to minimize the risk of individual companies.
By analyzing a relatively small number of exchange traded funds, you will be able to find some persistent macro-economic trends in the market that give you an opportunity to make money even when all markets seem to be going down.
As with all investments, these have been hypothetical examples and you should do your own due diligence, and consult with a financial professional.