Demystifying Pairs Trading: The Role of Volatility and Correlation

Abstract

This paper investigates how the two technical drivers, volatility and correlation, influence the algorithm of the investment strategy pairs trading. We model and empirically prove the connection between the rule-based pair selection, the trading algorithm, and the total return. Our insights explain why pairs trading profitability varies across markets, industries, macroeconomic circumstances, and firm characteristics. Furthermore, we critically evaluate the power of the traditionally applied pair selection procedure. In the US market, we find risk-adjusted monthly returns of up to 76bp for portfolios, which are double sorted on volatility and correlation between 1990 and 2014. Our findings are robust to liquidity issues, bid-ask spread, and limits of arbitrage.

Keywords: Pairs trading, Relative-value arbitrage, Volatility, Market Efficiency, Limits of arbitrage

JEL Classification: G11, G12, G17