Using Fundamentals to Improve Pairs Trading Strategy

A related paper has been added to:

#12 – Pairs Trading with Stocks

Authors: Mazo, Lafuente, Gimeno

Title: Pairs Trading Strategy and Idiosyncratic Risk. Evidence in Spain and Europe.



Pairs trading strategy’s return depends on the divergence/convergence movements of a selected pair of stocks’ prices. However, if the stable long term relationship of the stocks changes, price will not converge and the trade opened after divergence will close with losses. We propose a new model that, including companies’ fundamental variables that measure idiosyncratic factors, anticipates the changes in this relationship and rejects those trades triggered by a divergence produced by fundamental changes in one of the companies. The model is tested on European stocks and the results obtained outperform those of the base distance model.

Notable quotations from the academic research paper:

"The purpose of this research is to propose a pairs trading model that increases return compared to the model of distance (Gatev et al., 2006). We will introduce some rules in the model, based on fundamental variables, so that persistent divergence in the relationship of the prices of the two selected stocks could be foreseen. When we analyze the results of the distance method in previous works, we found that the number of trades with losses was high and the increase of such trades was one of the reasons of the decline of pairs trading strategy return.

Depending on the reason why a divergence on a stock price pair leads to execute the trade, it will be more or less likely that the stock price pair will convergence again. Thus, if the stock price pair divergence is due to irrational investors that leads to liquidity tensions, later convergence is likely to happen. However, if the reason of such divergence is new information about the companies’ fundamentals, divergence is likely to remain and there will be another equivalence relation between both stocks (Andrade et al., 2005). This is the starting point of this paper: beginning from the basic model of distance, we test which variables related to companies’ performance could anticipated if divergence is temporal or permanent.

The variables we use in the model are selected from analysts’ consensus. The data are obtained from FactSet, a financial information provider. The reason to choose the values provided by analysts’ consensus is that they consider the implicit information in analysts’ recommendations that follow a certain stock.
The variables considered in the model are:
a) Earnings per Share in the next 12 months. (EPS).
b) Book Value per Share (BVPS).
c) Target Price (TP).
d) Recommendation.
e) Knowledge of the firm, measured as the number of estimations of each stock.

Empirical analysis of the proposed model confirms the hypothesis of the paper: including in the model variables that represent idiosyncratic risk of a firm outperforms basic pairs trading strategy (distance model). In fact, adding ES, BVPS and TP variables leads to better returns in the analyzed portfolios of IBEX 35 index, Euro Stoxx 50 index and Stoxx Europe 50 Index."

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