How Some Bankers Made a Million by Trading Just Two Securities?
Luxembourg School of Finance
Aalto University School of Business
February 26, 2011
In this paper, we study a pair trading strategy that utilizes short-term return reversals in the stock market. Our analysis is based on a theoretical model of the short-term return reversal phenomenon presented in Suominen and Rinne (2009). That paper was applied empirically to estimate the returns to a contrarian, liquidity providing trading strategy in Rinne and Suominen (2010). In this paper, we study the returns to that same trading strategy in the context of a single pair trade in the Finnish stock market. We show that for this particular pair trade, the returns to the liquidity providing trading strategy were extremely high: weekly returns were more than 2% (of the long position), corresponding to annualized returns of more than 200% before transaction costs. These returns are highly statistically significant and exceed well any reasonable estimates for transaction costs. In recent years, possibly due to larger amount of capital devoted to statistical arbitrage and lower transaction costs for traders, the pre-transaction cost returns from this trading strategy have decreased.
Our evidence is consistent with the idea that these returns were compensation from providing liquidity to the market. On the days when the expected returns to our trading strategy were the highest, the volume was abnormally high and, judging from active brokers net trades, nearly 45% of all brokers (or their customers) engaged in pair trading in accordance with our trading strategy, being counterparts largely to few brokers that traded large quantities of stocks inconsistent with our strategy. We show that three brokerage houses (or their customers) made more than a million (pre transaction costs) by engaging in pair trading involving just these two securities.
Number of Pages in PDF File: 25
Keywords: pair trading, short-term reversals
JEL Classification: G10, G11, G12
Date posted: March 27, 2011