Aside from the risks associated with pairs trading, there are a number of disadvantages to this investment technique of which traders should be aware. Perhaps the most obvious disadvantage is that each trade necessitates twice the commissions and fees. If an investor were to simply go long, he or she would pay one commission to enter and one to exit the trade. A pairs trader, however, must pay two commissions to enter and two commissions to exit each trade. Depending on the particular strategy employed, this can add up quickly. Commissions should be factored into any historical modeling to determine if the strategy can, in fact, make a profit.

The outcomes of execution risk are also a disadvantage in pairs trading. Slippage, partial fills and bid-ask spreads can reduce profits. The bid-ask spread is the amount by which the ask price exceeds the bid, or the difference in price between the price a buyer is willing to pay for a security (bid), and the and the price a seller wants for that security (ask). The trading volume of the securities greatly affects the bid-ask spread; instruments that trade under higher volume tend to have smaller bid-ask spreads, while those that are thinly traded often have larger bid-ask spreads.

Because many pairs trading strategies rely on exploiting very small price changes, the technique may be most efficient for traders who are well-capitalized and who have the ability to enter large positions (i.e., lots of trading capital and willingness to leverage positions). True to nearly any style of investing, smaller traders may need to take a different approach (and employ a different strategy) than the large, institutional pairs traders.

Next: Advantages of Pairs Trading »


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