How do you explain the pair trading profit?

Pair trading is a simple trading idea famous 15 years ago. The 2 step methodology is simple. First, you find one pair of stocks moving together. Then you monitor the spread, and when the spread is greater than the threshold, you bet the spread gets smaller. The profit decay in the recent decade after researchers have already tried all possible functions to extract information from prices and all cointegration measures to measure the co-movement between two stocks. It is unlikely to pick up the easy money now, but we can review the latent risk factor behind the pair trading alpha. This blog summarizes some papers trying to explain the profit of pair trading, and it might give us some hints of its current failure.

1. providing liquidity to uninformed traders
If uninformed traders trade one leg in pairs due to liquidity reasons, the un-balanced order flow will influence the stock price. While the uninformed trader does no trade another stock in the pair, we can see the spread changes because of trading’s temporary effect. If the trading is uninformed, there is no permanent effect, and the temporary impact would decay, which narrows the spread. As a result, pair trading provides liquidity to the uninformed traders, and the activity to provide liquidity gets rewarded from the market.

2. providing liquidity during earning announcement
Suppose there are earning announcements or company activities. In that case, risk-averse market makers are less likely to provide liquidity, and the uninformed traders would like to reduce trading liquidity due to information inferiority. The spread between pairs is more likely to widen due to low trading activity. Pair trading provided liquidity to this challenging condition expects to get profit.

3. lead-lag effect
Information is easily absorbed into the liquid stock, and it diffuses into the illiquid stocks. In the equilibrium between informed traders, uninformed traders, and market makers, the informed trader tries to hide in the uninformed trade wave. So they prefer to use liquid stock to express their view; otherwise, if they are located by market makers, they would receive a worse quotation (information adjusted quotation). In this situation, pair trading accelerates information diffusion and provides liquidity to informed traders, which should be rewarded by the market.

4. high distraction
When investors expect a high quantity of information, just like before an unemployment data announcement, they focus more on the whole market, not single names. They are distracted from the paired comparison, and the spread is more likely to widen. In this situation, pair trading provides liquidity to the market before significant events, and they correct most investors from distraction.

As a result, we can decompose the return from pair trading into each category and find the best strategy based on our risk preference. As the proverb goes, there is no alpha in the market, but risks we do not know how to decompose. Risk decomposition makes alpha robust and keeps us away from data snooping, and we can choose a strategy to follow our heart (risk preference).

Reference

Alexander, C. and Dimitriu, A. (2005). Indexing and statistical arbitrage. The Journal of Portfolio Management, 31(2):50–63.

Papadakis, G. and Wysocki, P. (2007). Pairs trading and accounting information.

Engelberg, J., Gao, P., and Jagannathan, R. (2009). An anatomy of pairs trading: the role of idiosyncratic news, common information and liquidity. In Third Singapore International Conference on Finance