Pairs Trading: Risks
  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

Pairs Trading: Risks

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.

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
RELATED TERMS
  1. Model Risk

    A type of risk that occurs when a financial model used to measure ...
  2. Long-Term Capital Management - LTCM

    A large hedge fund led by Nobel Prize-winning economists and ...
  3. Slippage

    The difference between the expected price of a trade, and the ...
  4. Financial Modeling

    The process by which a firm constructs a financial representation ...
  5. Fill

    The action of completing or satisfying an order for a security ...
  6. Business Model

    The plan implemented by a company to generate revenue and make ...
RELATED FAQS
  1. What models should I use to make arbitrage trades?

    Learn about different types of arbitrage models and techniques, and discover why classic arbitrage opportunities are very ... Read Answer >>
  2. How do I use the news to find arbitrage opportunities?

    Learn what risk arbitrage trading is and how this type of arbitrage trading opportunity is available to individual retail ... Read Answer >>
  3. What is the difference between arbitrage and hedging?

    Dive into two very important financial concepts: arbitrage and hedging. See how each of these strategies can play a role ... Read Answer >>
  4. What skills should I acquire to take advantage of arbitrage trading?

    Understand what arbitrage trading involves and what the necessary skill set is that a trader must develop in order to master ... Read Answer >>
  5. What is arbitrage pricing theory?

    Find out what arbitrage pricing theory is and how it can theoretically be used by investors to generate risk-free profit ... Read Answer >>
  6. What is the difference between arbitrage and speculation?

    Arbitrage and speculation are very different strategies. Arbitrage involves the simultaneous buying and selling of an asset ... Read Answer >>
Hot Definitions
  1. Reverse Mortgage

    A type of mortgage in which a homeowner can borrow money against the value of his or her home. No repayment of the mortgage ...
  2. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  3. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  4. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  5. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  6. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
Trading Center