Analysis of Financial Time Series, Third Edition

8.8 Pairs Trading

Pairs trading is a market-neutral trading strategy. There are several versions of pairs trading in the equity markets. In this section, we focus on the statistical arbitrage pairs trading, which makes use of the ideas of cointegration and error correction model discussed in the chapter. Our discussion will be brief. For more information concerning pairs trading and statistical arbitrage, see Vidyamurthy (2004) and Pole (2007).

The general theme for trading in the equity markets is to buy undervalued stocks and sell overvalued ones. However, the true price of a stock is hard to assess. Pairs trading attempts to resolve this difficulty using the idea of relative pricing. Based on the arbitrage pricing theory (APT) in finance, if two stocks have similar characteristics, then the prices of both stocks must be more or less the same. If the prices differ, then it is likely that one of the stocks is overpriced and the other underpriced. Pairs trading involves selling the higher priced stock and buying the lower priced stock with the hope that the mispricing will correct itself in the future. Note that the true prices of the two stocks are not important. The observed prices may be wrong. What is important is that the observed prices be the same. The gap (properly scaled) between the two observed prices is called the spread. For pairs trading, the greater the spread, the larger the magnitude of mispricing and the greater the profit potential. Before discussing a trading ...