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Empirical Investigation of an Equity Pairs Trading Strategy

Last Updated on 10 February, 2024 by Rejaul Karim

In the impending realms of financial strategy, the research paper “Empirical Investigation of an Equity Pairs Trading Strategy” delves into the intricacies of a pairs trading approach, unfolding a narrative of substantial and noteworthy abnormal returns.

Authored by Huafeng (Jason) Chen, Shaojun Jenny Chen, Zhuo Chen, and Feng Li, the study dissects the trading signal into two distinct components—short-term reversal and pairs momentum—each wielding unique dynamics and cross-sectional properties. The pairs momentum, intriguingly, finds its roots in the one-month iteration of industry momentum.

Consequently, the profits derived from pairs trading unfurl as a harmonious blend of short-term reversal dynamics and a nuanced manifestation of industry momentum. This empirical exploration not only sheds light on the profitability of the strategy but also unravels the nuanced interplay of factors orchestrating its success.

Abstract Of Paper

We show that an equity pairs trading strategy generates large and significant abnormal returns. We find that two components of the trading signal (short term reversal and pairs momentum) have different dynamic and cross-sectional properties. The pairs momentum is largely explained by the one month version of the industry momentum. Therefore, the pairs trading profits are largely explained by the short term reversal and a version of the industry momentum.

Original paper – Download PDF

Here you can download the PDF and original paper of Empirical Investigation of an Equity Pairs Trading Strategy.

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Author

Huafeng (Jason) Chen
Fudan University – Fanhai International School of Finance (FISF)

Shaojun Jenny Chen
University of British Columbia (UBC); Connor, Clark, and Lunn Investment Management

Zhuo Chen
Tsinghua University – PBC School of Finance

Feng Li
Shanghai Advanced Institute of Finance, Shanghai Jiaotong University

Conclusion

In conclusion, our empirical exploration into an equity pairs trading strategy unveils a compelling narrative of substantial and noteworthy abnormal returns. Deconstructing the trading signal, we discern distinct characteristics in two pivotal components—short-term reversal and pairs momentum.

These components exhibit divergent dynamics and cross-sectional properties, enriching our understanding of the strategy’s inner workings. Notably, pairs momentum finds its explanation in the one-month iteration of industry momentum, illuminating the intertwined nature of these phenomena.

Ultimately, the profitability of our pairs trading strategy is intricately woven from the threads of short-term reversal and a nuanced rendition of industry momentum, shedding light on the multifaceted dynamics that underpin successful equity pairs trading.

Related Reading:

Pairs Trading in the UK Equity Market: Risk and Return

On the Persistence of Cointegration in Pairs Trading

FAQ

– What is the main focus of the research paper “Empirical Investigation of an Equity Pairs Trading Strategy,” and how does it contribute to our understanding of pairs trading?

The study explores the intricacies of an equity pairs trading strategy, emphasizing the generation of substantial and significant abnormal returns. It dissects the trading signal into two components—short-term reversal and pairs momentum—unveiling their distinct dynamics and cross-sectional properties. The research enriches our understanding of pairs trading by revealing the nuanced interplay between these components and their role in driving abnormal returns.

– What are the two distinct components of the trading signal, and how do they contribute to the profitability of the pairs trading strategy?

The trading signal is deconstructed into two components: short-term reversal and pairs momentum. These components exhibit different dynamic and cross-sectional properties. While short-term reversal contributes to the profitability of the pairs trading strategy, pairs momentum is largely explained by the one-month version of industry momentum. The research suggests that the profitability of pairs trading is intricately woven from the combined effects of short-term reversal and a nuanced manifestation of industry momentum.

– How does the study shed light on the inner workings of the pairs trading strategy, and what role does the one-month iteration of industry momentum play in the pairs momentum component?

The research provides insights into the inner workings of the pairs trading strategy by unraveling the characteristics of its components. Notably, the pairs momentum component finds its explanation in the one-month iteration of industry momentum. This highlights the interconnected nature of pairs momentum and industry momentum, contributing to a nuanced understanding of the factors influencing the success of equity pairs trading.

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