A study by Deutsche Bank
The principle of pairs trading is remarkably simple. An investor finds assets whose prices moved together historically, open a trade by shorting the winner and buying the loser when the spread between them widens. The trade is closed when the spread converges. Although, it may sound simple…the Devil is in the detail!
Over the years, pairs trading has become one of the most popular statistical arbitrage strategies. The strategy exploits temporary anomalies between prices of assets that have some equilibrium relationship. While methods may differ in sophistication, all implementations rely on the use of statistical analysis of historical prices to identify pair candidates with stable inter-relationships.
The main challenge in building such strategies is that, often, cointegration between two assets breaks down out-of-sample – making the trade a losing proposition.