Illuminating the Profitability of Pairs Trading: A Test of the Relative Pricing Efficiency of Markets for Water Utility Stocks

This article examines the profitability of a pairs trading strategy derived solely from historic price dynamics and contrarian principles. The authors find that the profitability of the self-financing strategy hinges on a cointegrated relationship, which previous research shows also implies an error-correcting relationship. With an error-correcting relationship at play, their model allows the movement of a temporary pricing flaw back to its expected value to be predicted with a surprisingly high level of accuracy. They find that although they are not able to foresee the movement of the cointegrating leader, that move generates a predictable response from the cointegrating follower, which the pairs trading strategy is able to profit from. Their results are robust to a variety of scenarios; most interestingly is when the same security is the leader in one combination but the follower in another. In this case, the security in question is predictable only when it is the follower.