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

68 Pages Posted: 22 Jan 2009 Last revised: 20 Mar 2009

Joseph Engelberg

University of California, San Diego (UCSD) - Rady School of Management

Pengjie Gao

University of Notre Dame - Mendoza College of Business

Ravi Jagannathan

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); Indian School of Business (ISB), Hyderabad

Date Written: November 17, 2008

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

Suggested Citation

Engelberg, Joseph and Gao, Pengjie and Jagannathan, Ravi, An Anatomy of Pairs Trading: The Role of Idiosyncratic News, Common Information and Liquidity (November 17, 2008). Third Singapore International Conference on Finance 2009. Available at SSRN: https://ssrn.com/abstract=1330689 or http://dx.doi.org/10.2139/ssrn.1330689

Joseph Engelberg

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

Pengjie Gao

University of Notre Dame - Mendoza College of Business ( email )

246 Mendoza College of Business
Notre Dame, IN 46556-5646
United States
(574) 631-8048 (Phone)

Ravi Jagannathan (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
429 Andersen Hall
Evanston, IL 60208
United States
847-491-8338 (Phone)
847-491-5719 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Indian School of Business (ISB), Hyderabad ( email )

Hyderabad, Gachibowli 500 019
India

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