Stock Price Co-Movement and the Foundations of Pairs Trading
55 Pages Posted: 10 Feb 2018
Date Written: January 22, 2018
We study the theoretical implications of cointegrated stock prices on the profitability of pairs trading strategies. If stock returns are fairly weakly correlated across time, cointegration implies very high Sharpe ratios. To the extent that the theoretical Sharpe ratios are "too large," this suggests that either (i) cointegration does not exist pairwise among stocks, and pairs trading profits are a result of a weaker or less stable dependency structure among stock pairs, or (ii) the serial correlation in stock returns stretches over considerably longer horizons than is usually assumed. Empirically, there is little evidence of cointegration, favoring the first explanation.
Keywords: Pairs trading, Stock price co-movement, Cointegration
JEL Classification: C22, G1
Suggested Citation: Suggested Citation