Basic ideas:

  1. Statistical strategy -> try to build correlations between different stocks
  2. Example
    When a well established price correlation between A and B broke down, i.e. stock A traded up while B traded down, they would sell A and buy B, betting that the spread would eventually converge.
  3. Advantages: Market Neutrality
    • Market neutral: trading strategies which are independent of market movements are said to be market neutral
    • Pair trading is mean-reverting strategy, assuming that prices will revert to historical trends and it is largely self-funding.
  4. Risks:
    • Transaction cost
    • Involution
    • The increased divergence -> rational response to news about one of the companies

Strategy Specification

  1. Correlation built:
    Pairs were formed based on price correlations over a 12-month period, starting every month
  2. Trading:
    Each pair was then traded (possibly multiple times) over the next six months.
    The pair was “bought” when its ratio spread was outside two standard deviations of its 12-month spread. If normally distributed, this should happen about 5% of the time.
  3. Pair Formation:
    A matching partner for each security was found by minimizing the squared deviations between the two normalized daily price series, where dividends were reinvested.
  4. Return Computation:
    Pairs that open and converge will have positive cash flows; Pairs that open but do not converge will have positive or negative cash flows on the last day of the trading interval when all positions are closed out