37 Pages Posted: 11 Nov 2010 Last revised: 2 Oct 2012
Date Written: January 31, 2011
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: Suggested Citation