Binh Huu Do

Does Simple Pairs Trading Still Work

Despite confirming the continuing downward trend in profitability of pairs trading, this study found that the strategy performs strongly during periods of prolonged turbulence, including the recent global financial crisis. Moreover, alternative algorithms combined with other measures enhance trading profits considerably, by 22 bps a month for bank stocks. Pairs trading is a relative value arbitrage in equity markets and is particularly attractive to hedge funds that seek to profit from temporary price deviations between stocks of close economic substitution. The scant research on this topic is mostly confined to seminal works that have documented economically and statistically significant, albeit declining, profits (on the order of 1 percent a month) from the use of a very simple pairs trading rule. This remarkable success has not been subjected to independent scrutiny, unlike other well-documented anomalies, such as momentum trading. We re-examined and expanded evidence on pairs trading in the U.S. market by using an extended dataset covering July 1962–June 2009. We confirmed a continuation of the declining trend in profitability over time, with the mean excess return for the portfolio of the top 20 pairs dropping precipitously, from 0.86 percent a month for 1962–1988 to 0.37 percent for 1989–2002 and to just 0.24 percent for 2003–2009. Although the literature suggests that this decline is the consequence of increased competition within the growing hedge fund industry, which competes away the same opportunities, careful analysis shows that not to be the case in pairs trading. We argued that pairs trading is essentially a risky arbitrage; thus, its performance depends on not only the state of market efficiency but also the degree of arbitrage risks facing arbitrageurs. These risks encompass fundamental risk, noise-trader risk, and synchronization risk, all of which work to prevent or delay arbitrage or to inflict losses on arbitrageurs. Using a simple attribution analysis, we were able to show that the “market efficiency” story, in which the hedge fund factor is just one component, is only partly to blame for the decline. Instead, we found that the worsening arbitrage risks facing pairs traders contribute up to 70 percent of the drop in profits. We also found that pairs trading performed particularly strongly during recent periods of prolonged turbulence, namely, the 2000–02 bear market and the 2007–09 global financial crisis. Although this finding seems counterintuitive, the increase in arbitrage risks during these periods of panic was outweighed by a corresponding decrease in market efficiency. Thus, some arbitrageurs have overcome worsening arbitrage risks to successfully exploit mispricings that appear to be abundant in such turbulent periods. We further proposed alternative algorithms that incorporate two additional pair-matching criteria: industry homogeneity and historical frequency of reversal in the price spread (in addition to the conventional price spread metric). Homogeneity involves matching securities within the same and narrowly defined industry groups to ensure close substitution by classification and lower divergence risk. To some extent, this metric can be viewed as a first step toward incorporating a fundamental aspect in pairs trading, which is traditionally a technical concept. Reversal frequency, computed as the number of zero crossings by the normalized price spread, measures how frequently two securities crossed each other in the past. A high number of zero crossings signifies a “track record” of frequent mispricings within a pair that were successfully corrected by market participants. When combined with the SSD and homogeneity metrics, this track record measure has been found to enhance trading profits considerably, by 22 bps a month for bank stocks.

Relative Performance of Dynamic Portfolio Insurance Strategies: Australian Evidence

This paper simulates the performance of synthetic put portfolio insurance and Constant Proportion Portfolio Insurance (CPPI) using Australian data for the period from 1992 to 2000. These strategies are implemented by trading in the index and bills and simulation is conducted across 18 scenarios. We find that while the CPPI dominates in scenarios using daily rebalancing, the synthetic put strategy delivers better outcomes when value based triggers are used. More importantly, although the two per cent market move trigger emerges as the optimal rebalancing choice, overall, neither strategy appears justifiable in terms of achieving downside protection or allowing upside gain.

Does the 2008 short sale ban affect the enforcement of the Law of One Price? Evidence from Australia

Using evidence from pairs trading in Australia’s equity market, we study the effect of the 2008 worldwide ban on short selling on the Law of One Price (LOP). We find that the ban surprisingly does not hinder the enforcement of the LOP. Violations did arise rather frequently in the turbulent market during the ban period; however, they were subsequently corrected, with prices of close economic substitutes promptly converging to parity. We show that the working of the LOP is not driven by professional arbitrageurs. We suggest that rational, long‐only investors are likely to be the enforcer of the LOP, as these investors who are unbound by the ban, simply sell their holdings of stocks that are overpriced relative to their close economic substitutes.

Co-existence of short-term reversals and momentum in the Australian equity market:

Small stocks tend to reverse, whereas large stocks tend to trend over a one-month horizon, which explains the lack of short-term reversals in the Australian market as a whole. However, large stocks exhibit intra-industry reversals, in which industry winners underperform industry losers in the subsequent month, when controlling for price momentum. Conversely, once this intra-industry reversal is neutralised, large stocks display momentum behaviour, in which market winners outperform market losers. These conditional strategies generate positive, significant risk-adjusted returns on large stocks in Australia. This paper documents significant industry momentum, as winning industries outperform losing industries in the following month. This industry momentum effect dominates the intra-industry reversal. The paper also finds evidence that conditional reversals are driven by illiquidity and are inhibited by stock prices under-reacting to earnings announcements.

Cointegration and Relative Value Arbitrage

We examine a new method for identifying close economic substitutes in the context of relative value arbitrage. We show that close economic substitutes correspond to a special case of cointegration whereby individual prices have approximately the same exposure to a common nonstationary factor. A metric of closeness constructed from the cointegrating relation strongly predicts both convergence probability and profitability in cointegration-based pairs trading. From 1962 to 2013, a strategy of trading cointegrated pairs of near-parity generates 58 bps per month after trading costs, experiences a 71% convergence probability and outperforms a strategy of pairs selected by minimized price distances.