Pairs trading is a market-neutral strategy that exploits temporary deviations in the price relationship between two historically correlated or cointegrated assets by going long the undervalued asset and short the overvalued asset, aiming to profit from spread mean reversion.
There is an emerging study in the literature that highlights the diminishing profitability of pairs trading. Reference [1] revisits this subject. It studied ETF pairs, using cointegration on the pair ratio as the criterion for evaluating pairs.
The authors pointed out,
The study confirms that the effectiveness of pairs trading is heavily contingent upon the stability and persistence of cointegration relationships between asset pairs. Notably, lowering the z-score threshold from 2 to 1.5 revealed more trading opportunities and improved total profits, but the strategies still faced significant challenges due to short trading windows and increased volatility. These findings are consistent with prior research, such as Do and Faff (2010) Rad et al. (2016), which suggest that the profitability of pairs trading has diminished over time due to increased market complexities and risks.
The effectiveness of ETF pairs trading strategies is highly sensitive to prevailing market conditions, which can significantly impact profitability and risk. Periods of heightened volatility, such as during financial crises or geopolitical uncertainty, can disrupt mean-reverting relationships, causing pairs to diverge for extended periods instead of reverting.
Potential improvements to the pairs trading strategy include the development of adaptive thresholds that adjust based on market volatility or other indicators, enhancing the strategy’s robustness in different market environments. Integrating fundamental analysis with cointegration testing could help identify more stable and profitable pairs, improving the strategy’s long-term viability.
This paper investigates an important issue that is not often discussed in pairs trading literature: the stability of cointegration. If it fails, then the pairs would no longer be profitable.
The paper presented several important conclusions:
- Lowering the z-score increases profitability but also raises P&L volatility and leads to deeper drawdowns, though recovery tends to be quick.
- Filtering pairs based on p-value improves performance.
- Using the VIX as a regime filter is effective.
- The study also recommends using the price ratio and testing for stationarity.
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References
[1] Kezhong Chen, Constantinos Alexiou, Cointegration‑based pairs trading: identifying and exploiting similar exchange‑traded funds, J Asset Manag (2025)
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