Disadvantages of Pairs Trading
  1. Pairs Trading: Introduction
  2. Pairs Trading: Market Neutral Investing
  3. Pairs Trading: Correlation
  4. Arbitrage and Pairs Trading
  5. Fundamental and Technical Analysis for Pairs Trading
  6. Pairs Trade Example
  7. Pairs Trading: Risks
  8. Disadvantages of Pairs Trading
  9. Advantages of Pairs Trading
  10. Pairs Trading: Conclusion

Disadvantages of Pairs Trading

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.

Advantages of Pairs Trading

  1. Pairs Trading: Introduction
  2. Pairs Trading: Market Neutral Investing
  3. Pairs Trading: Correlation
  4. Arbitrage and Pairs Trading
  5. Fundamental and Technical Analysis for Pairs Trading
  6. Pairs Trade Example
  7. Pairs Trading: Risks
  8. Disadvantages of Pairs Trading
  9. Advantages of Pairs Trading
  10. Pairs Trading: Conclusion
RELATED TERMS
  1. Bid And Asked

    A two-way price quotation that indicates the best price at which ...
  2. Right Hand Side - RHS

    The ask or offer price of a foreign exchange rate. A quote for ...
  3. Performance Drag

    The negative effect of transaction costs on the performance of ...
  4. Spread Indicator

    An indicator that shows the difference between the bid and ask ...
  5. Ask

    The price a seller is willing to accept for a security, also ...
  6. Forex Spread Betting

    A category of spread betting that involves taking a bet on the ...
RELATED FAQS
  1. What's the difference between bid-ask spread and bid-ask bounce?

    Understand the difference between the bid-ask spread that determines the buy or sell price for a stock and a bid-ask bounce, ... Read Answer >>
  2. What are the determinants of a stock's bid-ask spread?

    Stock exchanges are set up to assist brokers and other specialists in coordinating bid and ask prices. The bid price is the ... Read Answer >>
  3. How do I use the bid-ask spread to evaluate whether I should buy a particular stock?

    Understand the significance of the bid-ask spread for investors in making a decision on whether or not to purchase a particular ... Read Answer >>
  4. What types of stocks have a small difference between bid and ask prices?

    Learn more about bid-ask spreads and why stocks with high levels of liquidity and low levels of volatility usually have narrow ... Read Answer >>
  5. How do I use a limit order in conjunction with a bid-ask spread?

    Understand the concept of the bid-ask spread as it applies to trading and how it impacts the pricing of limit orders used ... Read Answer >>
  6. When is a buy limit order executed?

    Understand how buy limit orders work, and factors such as the bid-ask spread and market volatility that traders must consider ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center