Is Diversification Beneficial in Pairs Trading?

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Diversification offers several key benefits in trading and investment. Firstly, it helps to mitigate risk by spreading investments across different assets or asset classes. By diversifying, investors can reduce their exposure to any single investment and minimize the impact of potential losses. Secondly, diversification can enhance portfolio stability and smooth out returns over time. Different assets tend to have varying performance patterns, and by combining them in a portfolio, investors can potentially offset the volatility of one asset with the stability of another. Thirdly, diversification provides opportunities for potential growth and capitalizes on different market conditions. By diversifying, investors can position themselves to benefit from different market scenarios.

But does diversification work in a narrow, niche trading area such as pairs trading?

Reference [1] investigated this issue. It proposed a framework for diversification in pairs trading. Specifically, it proposed asset allocation schemes based on:

  • Mean-Variance analysis,
  • Mean reversion budgeting, and
  • Mean reversion ranking.

The authors pointed out,

We have presented a trading program that dynamically allocates capital to multiple mean reversion trading strategies. The approach is designed for trading multiple pairs in order to achieve diversification effects. Moreover, the dynamic rebalancing is adaptive to the current model estimates and based on the relative performance or path behaviors of the pairs in the portfolio. Our empirical experiments have shown that, for a given set of pairs traded, the allocation method plays a significant role in the success of the diversification framework.

In short, diversification is important and beneficial in pairs trading.

The research results are indeed encouraging as they serve as a motivating factor for further exploration of diversification benefits in specialized trading areas such as statistical and volatility arbitrage. The findings provide impetus to delve deeper into the potential advantages of diversification strategies within these niche domains.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Kiseop Lee, Tim Leung, and Boming Ning, A Diversification Framework for Multiple Pairs Trading Strategies, 2023, Risks 11(5):93

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