Rethinking Pairs Trading: Can Traditional Methods Still Deliver Returns?

Hello, 

Thank you for subscribing to my newsletter. In this issue, I’ll discuss the profitability of pairs trading. If there's a topic you'd like me to cover, feel free to let me know in the comments section on the website or by replying to this email. 

In this issue

• Pairs Trading: No Longer Profitable

  • Findings

• Pairs Trading: Still Profitable

  • Findings

• Closing Thoughts

• Gentle Introduction to Pairs Trading

Pairs trading is a market-neutral strategy that involves trading two correlated stocks or assets. The idea is to identify pairs that historically move together, and then take a long position in one and a short position in the other when they diverge, with the expectation that they will eventually revert to their mean relationship. 

The popularity of pairs trading has risen over the years. Naturally, this raises the question: is pairs trading still profitable, and is it worth investing time, money, and resources to find profitable pairs trading strategies? 

Pairs Trading: No Longer Profitable

There is a perspective among some researchers and traders that pairs trading may have lost its profitability over time due to increased competition and the efficiency of modern markets. 

Reference [1] argues that pairs trading is no longer profitable, especially when using basic approaches for pairs selection. 

Findings

• This paper focuses on the German stock market from 2000 to 2023, a market with relatively few analyses in this area.

• Basic strategies based on spread distance and cointegration barely cover transaction costs and often break even.

•  A copula-based method, especially when combined with simpler strategies, shows stronger performance, yielding an average portfolio return of around 170 basis points (bps) per month after transaction costs.

• The strategies are designed to be uncorrelated with systemic market risk, and empirical results confirm this.

• Sensitivity analyses indicate the robustness of the copula-based method and suggest possible refinements for further strategy enhancement.

Reference

[1] Sascha Wilkens, Pairs Trading in the German Stock Market: There’s Life in the Old Dog Yet.

Pairs Trading: Still Profitable

On the other hand, some argue that pairs trading remains profitable. Reference [2] supports this view, showing evidence of profitability even with classical pairs selection methods like the spread distance approach.

Findings

• The paper replicates Gatev et al.'s [3] pairs trading strategy using twenty years of stock price data, affirming robustness despite transaction costs in the current market.

• The top strategy achieves a compounded annual excess return of 6.2%, a notable finding given market dynamics.

• A broader stock pool mitigates outlier effects from events like delistings or stock splits, enhancing strategy performance compared to typical literature.

• The study examines two profit determinants in pairs trading: medium-term momentum and the default spread, correlating with the investor risk premium.

• These findings support Gatev et al.'s [3] hypothesis on arbitrage compensation for restoring market efficiency.

References

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

[3] Gatev, E., Rouwenhorst, K. G., and Goetzmann, W. (2006). Pairs trading: Performance of a relative value arbitrage rule.

Closing Thoughts

In my opinion, pairs trading is still profitable. However, it requires using a pairs selection method that isn’t obvious or widely adopted by others. I was somewhat surprised that, in Reference [2], the author still finds pairs trading profitable using a classical selection method.

What’s your experience with pairs trading? Let me know in the comments section or by replying to this email. 

Pairs selection is a critical step in developing a winning trading system. In a future issue, I’ll cover different pairs selection methods that could enhance profitability. 

Gentle Introduction to Pairs Trading

If you’re new to pairs trading or quantitative trading in general, the video below by Max Margenot provides an accessible introduction to the concept of pairs trading.