Improving Pairs Trading Profitability

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Pairs trading is a market-neutral strategy that involves taking long and short positions in two correlated assets to profit from their relative price movements. However, the profitability of pairs trading has been diminishing due to, in part, its growing popularity.

Reference [1] examined the profitability of pairs trading in the Swedish market and found that it has declined there as well. The authors pointed out,

The proposed trading strategy exhibits a limited capacity to generate returns surpassing transaction costs. Employing a threshold value higher than those used in previous studies has proven advantageous for trade execution frequency, striking an improved balance between effectiveness and frequency. A portfolio’s ability to yield a positive return proved to not correlate with the number of co-integrated equities but rather their quality, as the highest returns observed belonged to the industry sector with the fewest set of equity pairs.

Across different industry sectors, profitability varies, with the finance and industrial sectors consistently failing to yield cumulative positive returns when transaction costs are accounted for. In contrast, the energy and consumer staples sectors emerge as the most favorable markets for implementing the trading strategy, demonstrating that it is possible to achieve positive cumulative returns, although unpredictably. The probability of a positive spread trade and its magnitude were both improved when the position had a duration of one to two days.

In short, the authors demonstrate that the strategy returns are not correlated with the quantity of co-integrated pairs. Additionally, their findings suggest using a higher threshold for entering pair trades, which differs from previous research. The study also confirms that shorter-duration trades tend to yield more significant and positive returns.

We find their suggestions for improving profitability plausible; however, we note that their analysis is based on in-sample data, with no out-of-sample tests performed.

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

References

[1] Axel Södergård & David Alsenhed, Co-Integration Pair Trading on Swedish Equities, Are returns robust to transaction costs? Linköping University, 2024

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