Does Pairs Trading Deliver Alpha?

Follow us on LinkedIn

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

Further questions

What's your question? Ask it in the discussion forum

Have an answer to the questions below? Post it here or in the forum

LATEST NEWSA pair enjoyed pricey meals and bolted when it was time to pay. Their dine and dash ended in jail
A pair enjoyed pricey meals and bolted when it was time to pay. Their dine and dash ended in jail

LONDON (AP) — A Welsh couple who dined out on pricey meals and bolted when the bill came is now paying the price — behind bars. Bernard and Ann McDonagh were sentenced to prison on Wednesday for fraud after running up tabs they didn’t pay…

Stay up-to-date with the latest news - click here
LATEST NEWSKretinsky Says Royal Mail Needs Funds to Avoid ‘Deadly Spiral’
Kretinsky Says Royal Mail Needs Funds to Avoid ‘Deadly Spiral’

Czech billionaire Daniel Kretinsky, who plans to purchase the company that owns UK’s Royal Mail, says the British postal service needs new investment to be competitive.

Stay up-to-date with the latest news - click here
LATEST NEWSSaudi Arabia to Sell Aramco Stake That May Raise $10 Billion
Saudi Arabia to Sell Aramco Stake That May Raise $10 Billion

Saudi Arabia confirmed plans for a secondary share sale for its giant state-owned oil company in a deal that could raise over $10 billion for the kingdom as it seeks funds to pay for a massive economic transformation plan.

Stay up-to-date with the latest news - click here
LATEST NEWSHow to make money from medical research and donations
How to make money from medical research and donations

You can make good money from donating plasma or sperm on a regular basis. Other donations and scientific experiments can pay thousands of dollars.

Stay up-to-date with the latest news - click here
LATEST NEWSChristina Applegate's early MS symptoms show how the disease can be mistaken for everyday aches. What you need to know
Christina Applegate's early MS symptoms show how the disease can be mistaken for everyday aches. What you need to know

The faster people are diagnosed, the better the chance that medical intervention can help stave off the progression.

Stay up-to-date with the latest news - click here

Leave a Reply