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Choosing Price or Return Spreads for Equity Pairs Trading

Article Quant Q&A · Author: Yang
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Summary

The document raises a modeling choice in pairs trading: whether to define the spread between two assets using their prices or their returns. Price-based spreads can represent a relationship between asset levels, while return-based comparisons focus on relative performance. The author notes that convergence in relative returns could also produce a profitable long and short position, so the choice is not self-evident.

No comparison, backtest, or conclusion about which formulation performs better is provided. Instead, the document points to a published empirical study of an equity pairs strategy as an example of work using returns. That citation establishes a lead for further reading, but the text gives no details about the study's setup or findings. Readers should therefore treat the material as a framing of the question rather than evidence that either spread definition is superior; the appropriate choice remains dependent on the strategy's modeling assumptions and empirical evaluation.

Key ideas

  • Pairs strategies can define relative value using either price levels or returns.
  • A return spread frames convergence as relative performance between the two assets.
  • The document provides no direct empirical comparison of the two approaches.
  • A cited equity pairs study is offered as a reference for return-based analysis.

Tags

EquitiesPairs tradingStatistics
Full text
# In pair trading, we should look into the spread of price or return?


# In pair trading, we should look into the spread of price or return?












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I noticed that in the pair trading, some measure the spread on pricing and some measure the spread on return. Both methods make sense, it is intuitve to model price, but convergence of return means long stronger return and short weaker return which also leads to profit.

Has anyone compared the benefit of pair trading on spread or return?

Thanks in advance.

One example of pair on return instead of price comes from the following work:

Chen, H. (Jason), Chen, S. (Jenny), Chen, Z., & Li, F. (2019). Empirical Investigation of an Equity Pairs Trading Strategy. Management Science, 65(1), 370–389. https://doi.org/10.1287/mnsc.2017.2825

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.