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Are Pairs Trading Profits Robust to Trading Costs?

37 Pages Posted: 11 Nov 2010 Last revised: 2 Oct 2012

Binh Huu Do

Monash University; Financial Research Network (FIRN)

Robert W. Faff

University of Queensland

Date Written: January 31, 2011

Abstract

We examine the impact of trading costs on pairs trading profitability in the US equity market over the period 1963-2009. After controlling for commissions, market impact and short selling fees; we find that pairs trading remains profitable, albeit at much more modest levels. Specifically, we document a risk-adjusted return of about 30 basis points (bps) per month amongst portfolios of well matched pairs that are formed within refined industry groups. Strategies that are implemented on the top 30% largest stocks produce an average alpha of 24 bps per month. Pairs trading exhibits a lower risk and lower return profile than a short-term reversal strategy that sorts stocks relative to their industry peers. Notably, both of these forms of contrarian investing are largely unprofitable in the period post 2002.

Keywords: pairs trading, law of one price, trading costs, short-term reversal, contrarian strategies

JEL Classification: G11, G12, G14

Suggested Citation

Do, Binh Huu and Faff, Robert W., Are Pairs Trading Profits Robust to Trading Costs? (January 31, 2011). Available at SSRN: https://ssrn.com/abstract=1707125 or http://dx.doi.org/10.2139/ssrn.1707125

Binh Huu Do

Monash University ( email )

Building 11E
Clayton, Victoria 3800
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Robert W. Faff (Contact Author)

University of Queensland ( email )

St Lucia
Brisbane, Queensland 4072
Australia

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