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 doesn’t 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.
 
When Russia declared it was devaluing its currency, it defaulted on its bonds – in which LTCM was highly leveraged. 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 help 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. (For more, see: Massive Hedge Fund Failures.)

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 the strategy won’t execute 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 you are going long on stock ABC and the current market price is $50.15, you might expect (or, more accurately, hope for) that price. You might get filled, however, at $50.25 due to slippage, taking an automatic 10-cent loss (per share) on the trade. (For related reading, see: Introduction to Order Types.)
 
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.