PROFITABILITY OF A SIMPLE PAIRS TRADING STRATEGY: RECENT EVIDENCES FROM A GLOBAL CONTEXT

Jia Miao and Jason Laws ()
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Jia Miao: School of Accounting, Finance and Informatics, Kingston Business School, Kingston Hill Campus, Kingston University, London KT2 7LB, UK
Jason Laws: #x2020;Department of Economics, Finance and Accounting, Liverpool Management School, Chatham Building, Chatham Street, University of Liverpool, L69 7ZH, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2016, vol. 19, issue 04, 1-18

Abstract: Pairs trading strategy is a popular investment strategy, where traders long one stock and short the other stock. The trading profits are expected to be “immune” to any market conditions: being uptrend, downtrend, or sideways, instead the performance is determined by the relative performance of the pair. Following Gatev et al. [(1999) Pairs Trading: Performance of a Relative-Value Arbitrage Rule. Working Paper, Yale School of Management; (2006) Pairs trading: Performance of a relative-value arbitrage rule, The Review of Financial Study, 19, 797–827] and Do & Faff [(2010) Does simple pairs trading still work? Financial Analyst Journal, 66, 1–12], we examine whether the simple pairs trading rule is also profitable in markets outside of the US. We also examine whether the trading rule performs consistently during bull and bear markets, including the recent period of market turbulence. Our results show that in most countries, the strategy generates positive returns, without evidence of under performance during bear markets. Unlike prior research, we do not find that the trading profits diminish over recent years. The pairs trading strategy generates positive returns even after transaction costs. However, the returns deteriorate significantly at a higher level of transaction costs. It is also found that the correlation between the returns on our pairs trading portfolios and the returns on the corresponding stock market indexes is low, confirming its role as a diversifier to the traditional long only investments.

Keywords: Market neutral strategy; equity hedge; relative value strategy; price convergence and divergence (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1142/S0219024916500230

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