Although pure arbitrage is essentially a risk-free strategy, pairs trading (either as relative value arbitrage or StatArb) involves certain risks, including model risk and execution risk.

Model risk
As with nearly any investment that involves risk, pairs traders are exposed to model risk: a type of risk that occurs when the model used to create the strategy does not perform as expected. This can be due to a number of factors ranging from inaccurate research to flawed logic or calculations. The now-famous debacle that occurred at Long Term Capital Management (LTCM), for example, was attributed to model risk.

LTCM was a large hedge fund led by two Nobel Prize-winning economists and Wall Street traders. The firm’s primary strategy, based on sophisticated computer modeling, was to make convergence trades – pairs trades with a long position in a “cheap” security and short position in a “rich” one. Because they were looking for small price movements, leverage was a key component of LTCM’s strategy. At the start of 1998, the fund had $5 billion in equity and had borrowed more than $125 billion – a 30:1 leverage factor. LTCM believed the positions were very correlated, and thus, exposed to minimal risk.

Following Russia’s devaluation of the ruble (in which LTCM was highly leveraged in government bonds) and subsequent flight to quality, LTCM suffered massive losses of $4.6 billion and was in danger of defaulting on its loans. The fund was eventually bailed out with the hold of the Federal Reserve to thwart a global financial crisis.

Even the most carefully executed modeling can be flawed due to inaccurate research, unsound logic, changing circumstances and misinterpreted results.

Execution risk
This type of risk is another factor that can negatively impact the return for a pairs trade. Execution risk refers to the possibility that the strategy will not be executed as planned. For example, a trader may experience slippage in price or may receive a partial fill on an order, resulting in reduced profit potential. Slippage occurs when the price a trader receives for an order is less favorable than the one expected. For example, if we are going long on stock ABC and the current market price is $50.15, we might expect (or, more accurately, hope for) that price. We might get filled, however, at $50.25 due to slippage, taking an automatic 10-cent loss (per share) on the trade.

A trader might also receive a partial fill on an order. This occurs when a single order – for example, 1,000 shares of stock ABC – is broken down and filled at different prices. This particular trade might have 500 shares filled at $50.25 and the other 500 filled at $50.35 – or not at all if no shares are available.
Particularly if the pairs trading strategy relies on small price movements, a partial fill can significantly and negatively impact the potential for profits.


Next: Disadvantages of Pairs Trading »



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