Further on the Profitability of Pairs Trading

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Pairs trading is a market-neutral trading strategy that involves taking simultaneous long and short positions in two correlated stocks to profit from their relative price movements. There are recent research papers that argue that pairs trading is no longer profitable, especially when using traditional pairs selection methods. Reference [1], however, contradicts these results and demonstrates that pairs trading is still profitable. The author pointed out,

In this paper, we replicate the results of pairs trading strategy initially proposed by Gatev et al. (2006) using stock price data from the past twenty years. We find that pairs trading results are still robust under transaction cost despite the changing market environment, with our top performing strategy producing a compounded annual excess return of 6.2%. Compared to most papers in the literature, our best performing strategy uses a larger pool of stocks to average out the influence of outliers whose price jumped “overnight” in response to delisting or stock split news. We then analyze two determinants of pairs trading profit: the medium-term momentum factor and the default spread, which closely tracks the investor risk premium holding other macroeconomic variables constant. This supports Gatev et al. (2006)’s hypothesis that arbitrageurs are compensated for restoring the “Law of One Price”. Our empirical results are then confirmed in simulation, using equilibrium prices predicted by a psychology-based model.

In short, the paper shows that the benchmark pairs trading strategy specified in Gatev et al. [2] has delivered robust returns over the past twenty years. However, the risk nature of the strategy has changed over the past 20 years. Additionally, regressing pairs trading profitability on macroeconomic variables identifies aggregate risk premium as a determinant of pairs trading returns, suggesting that arbitrageurs are compensated for providing liquidity and enforcing the Law of One Price

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

References

[1] Xuanchi Zhu, Examining Pairs Trading Profitability, 2024, Yale University

[2] Gatev, E., Rouwenhorst, K. G., and Goetzmann, W. (2006). Pairs trading: Performance of a relative value arbitrage rule, 2006, Yale ICF Working Paper No. 08-03

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