Pairs trading is a market-neutral strategy that involves identifying a pair of assets with historically high correlation and taking positions based on their relative price movements. Traders typically take a long position in one asset and a short position in the other, aiming to profit from temporary divergences in their prices. The strategy relies on the assumption that the prices of the two assets will eventually converge. Pairs trading can be an effective way to potentially generate profits while minimizing exposure to broader market risks, making it a popular strategy among traders seeking to capitalize on short-term market inefficiencies.
While numerous research papers have extensively studied pairs trading within the equity market, there has been relatively limited focus on its application in the cryptocurrency market. Reference [1] specifically investigated pairs trading in the crypto market. The authors pointed out,
The main purpose of this paper is to show how the combination of pair selection methods and trading strategies perform on cryptos. It is done by inspecting whether the frequency of the selection period does impact the performance by choosing different pairs and by analysing the performance of different trading frequencies by showing the performance of daily versus hourly strategies…
The frequency of the formation period is not relevant. In fact, both methods always select the same pairs. Cointegration usually outperforms Distance, while Distance is hurt by transaction costs due to the numerous executions. Both methods are performing better than the buy-and-hold long/short strategies, but achieve less returns than CIX100 and BTC. The two coins are gaining extraordinary returns of 250.69% and 131.34% respectively, mainly due to an increase in crypto prices recorded between 2020 and 2021.
In short, cryptocurrency pairs trading outperformed the buy-and-hold long/short strategy but underperformed the traditional Buy & Hold.
While pairs trading underperformed the Buy and Hold, it’d be interesting to examine the strategy performance from the risk-adjusted return perspective.
Let us know what you think in the comments below or in the discussion forum.
References
[1] Lesa, Chiara and Hochreiter, Ronald, Cryptocurrency Pair Trading (2023). https://ssrn.com/abstract=4433530
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