Understanding the Profitability of Pairs Trading

This paper links uninformed demand shocks with the profits and risks of pairs trading. Usually employed by sophisticated investors, pairs trading is a relative value strategy that simultaneously buys one stock while selling another. In a market with limited risk bearing capacity, uninformed demand shocks cause temporary price pressure. A pair of stock prices that have historically moved together diverge when subjected to dierential shocks. Uninformed buying is shown to be the dominant factor behind the divergence. A strategy that sells the higher priced stock and buys the lower priced stock earns excess returns of 10.18% per annum. The marked-to-market returns of a pairs trading strategy are highly correlated with uninformed demand shocks in the underlying shares. Measuring pairs trading profits represents a succinct way to quantify the costs of liquidity provision (i.e., the costs of keeping relative prices in line.)