Assess the Pros and Cons of Pairs Trading
Pairs trading is a relatively simple-to-understand strategy — and one that ordinary UK investors can copy easily if they have access to online fundamentals-based data sources. (Fundamental-based data sources track information, such as the industry conditions, a company’s current financial condition and potential for future growth and so on, to determine the company’s intrinsic value.)
Pairs trading is hugely and rightly popular because it’s self-funding (the short sale returns can be used to buy the long position) and the price of a share does follow certain key trends or processes. In particular, the law of one price is hugely relevant.
This proposition states that two investments with the same payoff in every state of nature must have the same current value. A strong historical correlation suggests that they behave the same way in a large number of states, and so should be priced the same.
Simply put, the relationship between two correlated stocks is much more predictable and reliable than the outright prediction of the direction of a particular stock.
Pairs trading contains several potential challenges that you need to remember:
Immense popularity: Perhaps the most obvious problem is that huge numbers of hedge funds and other institutional investors have now piled into pairs trading and evidence suggests that it’s too popular for its own good.
The original Morgan Stanley group, for instance, was initially extremely profitable but disbanded with losses only a few years later. Many other big investment institutions have also decided to abandon pairs-based trading operations and focus on more unconventional strategies.
Transaction costs: Fees such as commissions and bid-ask spreads can eat up the theoretical returns in such an active strategy.
Spurious correlations: This most deadly of problems is when an investor thinks that she’s spotted shares that are closely correlated and yet in reality this relationship breaks down very quickly as outside forces intervene.