Gold Standard Pairs Trading Rules: Are They Valid?

TL;DR

This paper evaluates the validity of gold standard pairs trading rules over 30 years, revealing limited overall profitability but strong performance during bear markets and highlighting the influence of market factors on strategy parameters.

Contribution

It provides an empirical assessment of pairs trading strategies using common methods across a long historical period, emphasizing market condition adjustments.

Findings

Pairs trading strategies do not outperform benchmarks overall.

Strong performance observed during bear markets.

Market factors influence optimal strategy parameters.

Abstract

Pairs trading is a strategy based on exploiting mean reversion in prices of securities. It has been shown to generate significant excess returns, but its profitability has dropped significantly in recent periods. We employ the most common distance and cointegration methods on US equities from 1990 to 2020 including the Covid-19 crisis. The strategy overall fails to outperform the market benchmark even with hyperparameter tuning, but it performs very strongly during bear markets. Furthermore, we demonstrate that market factors have a strong relationship with the optimal parametrization for the strategy, and adjustments are appropriate for modern market conditions.