Does Pairs Trading Deliver Alpha?

Pairs trading is a market-neutral trading strategy that involves buying and selling two stocks simultaneously. The idea behind pairs trading is to find two stocks that are in co-movement and to take advantage of the differential in their price movement.

In order for pairs trading to be successful, you need to find two stocks that are:

– Highly correlated with each other

– Have a strong historical relationship

– Are in the same industry or sector

Once you have found two stocks that meet the above criteria, you can begin to monitor their price movement.  When one stock outperforms the other, you can take a long position in the stock that is outperforming and a short position in the stock that is underperforming.

Most published papers generally conclude that pairs trading can be a profitable strategy that delivers alpha if done correctly. Reference [1] presented, however, opposite results,

Overall, the result shows that the Hurst method cannot generate a strategy that can outperform the market and its performance is superior as compared to the cointegration method but it is not as compared to the correlation method. This result does not correspond with the result of some other papers in the past, which states that the cointegration method is superior compared to other methods. On the other hand, the result implies that the market is efficient, so we cannot build a trading strategy and earn an excess return on the market, which corresponds with the efficient market hypothesis, though the question of whether the market is efficient or not still remains debated in the literature. Moreover, pair trading strategy in case of all methods can sometimes outperform the market in recession stage but cannot in the expansion stage, which confirms the market neutrality of pair trading strategy.

In short, using the Hurst exponent method for selecting pairs, the authors concluded that pairs trading does not outperform Buy and Hold. This is contrary to the majority of publications.

Let us know what you think in the comments below.

References

[1] Quynh Bui, Robert Ślepaczuk, Applying Hurst Exponent in pair trading strategies on Nasdaq 100 index, Physica A 592 (2022) 126784

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