An Anatomy of Pairs Trading: The Role of Idiosyncratic News, Common Information and Liquidity

Abstract

"Pairs trading" involves taking a bet that the price paths of two stocks that have historically moved together will converge again after any divergence. Consistent with the view that profits to pairs trading comes through market making, i.e., short term liquidity provision and price discovery; we find that pairs trading profits are higher when the initial divergence is due to (a) news that temporarily reduces the liquidity of one of the stocks in the pair, or (b) news that affects both stocks in the pair, and there are a priori reasons to believe that one stock reacts faster to such news. Profits are lower when the initial divergence in prices is associated with value relevant news specific to a stock in the pair. Pairs involving smaller, less liquid and more volatile stocks tend to converge faster after initial divergence. When one of the stocks in the pair is more likely to have sluggish response to common information as evidenced by less common sell side coverage and institutional holdings, the risk of a margin call due to further divergence is lower. Closing out positions that do not converge within 10 days leads to higher risk adjusted returns ignoring transactions costs when compared to holding positions for 6 months.

Keywords: Pairs Trading, News, Liquidity Shocks, Convergence Trade

JEL Classification: G11, G12, G14