Case Study: Pairs Trading

Andrew Coatsworth
Finance 466
Professor Brogaard
December 3, 2015

I. Introduction
The purpose of this report is to analyze a pairs trading strategy that holds Chevron and
Occidental Petroleum Stocks over a period from January 2nd, 2014 until December 31st, 2014.
These companies were chosen because they are both key players in the oil industry.
Additionally, the prices of the 2 stocks tend to move together as exemplified by their 84.3%
correlation. Since Occidental Petroleum and Chevron are expected to move together, the pairs
trading strategy will attempt to exploit points where the stocks move in opposite directions.
However, in reality, if the stocks follow the trend of high correlation during the investment
period, the pairs trading strategy will fail to earn lucrative profits.
During these trading periods, the stock with the rising price will be held in a long position
while the stock with the declining price will be sold short. These points of separation are
calculated when the actual daily price difference of the two stocks exceeds a set normal price
difference (to begin, the point is the average normal price difference from January 1st until March
3rd and then adjusts when the position is force closed) by $4 (positively or negatively). The
difference of the two normal price differences is noted as a spread. If the spread is positive,
Chevron is held in a long position because the positive spread suggests that Chevron, the stock
with the higher price, is driving the price difference. When Chevron is held long, Occidental
Petroleum is sold short. However, if the spread is negative, Occidental Petroleum is held long
and Chevron is sold short because the negative spread suggests that the lower priced stock,
Occidental, is driving the price difference. In either case, each stock purchase or short sale is for
$10,000. The positions are closed either when the spread decreases to $2.20 or less, or when the
positions are open for 15 days. If the positions are open for 15 days, they are force closed and
the new normal price difference becomes the normal price difference of the two stocks from the

day of the force close. The new spreads are then calculated using this adjusted normal price
difference.
In the case of the examined strategy, during the design period from January 1st, 2014
until June 30th, 2014, six trades were completed. Considering the pairs trading strategy, six
trades seemed to be neither too high nor too low. If the open and close rules were set in fashion
to promote
trading, the
would run
losing any
transaction
However,
were set in

Purcha
se
Date
1/2/14
1/21/14
2/10/14
3/26/14

more
Sale
Date
1/10/1
4
1/31/1
4

Long
Stock

Short
Stock

OXY

CVX

OXY

CVX

3/3/14
4/14/1
4
5/16/1
4
6/17/1
4

CVX

OXY

Total
Profit
$252.1
3
$458.5
7
$(217.
66)

Retur
n

OXY

CVX

$(0.72) 0.00%

1.26%
2.29%
1.09%

strategy
the risk of
profits to
costs.
if the rules

a fashion
$16.79 0.08%
$166.7
to reduce
trading, the
5/29/14
CVX
OXY
5 0.83%
Averag
strategy
would run
e
0.56%
the risk of missing out on potential gains as too few trades are made. An open spread of $4 and a
4/28/14

OXY

CVX

close spread of $2.20 attempts to balance the costs and benefits of different potential rules.
Although the rules were set in an attempt to find an optimal number of trades, during
design period it became clear that this strategy is not reliably profitable.

While the first two trades offered moderately positive returns over a very short investment

trade

Purcha
se
Date

in a loss

7/23/14

1.09%.

9/26/14

8/1/14
10/16/1
4

swing in

10/28/1
4

11/17/1
4

OXY

CVX

$(227.9
7)

12/9/14

12/30/1
4

OXY

CVX

$(60.03
)

horizon,

suggests
pairs

Sale
Date

Long
Stock

Short
Stock

Total
Profit

OXY

CVX

CVX

OXY

$81.51
$353.9
8

strategy

Retur
n
0.408
%
1.770
%
1.140
%
0.300
%
0.184
%

the third
resulted
of
This
returns
that this
trading
is not

low risk. Additionally, after losing 1.09%, of the next two trades, one essentially broke even and
the other earned a very small profit. Yet, despite the mixed results, the final trade of the design
period earned a positive return of .83%, again over a relatively short investment horizon. On
average, the trades earned a return of .56% during the design period. The trades earning negative
returns drove significantly down the average return. However, since four out of the six trades
completed during the design period earned positive returns, the designed strategy was
determined to be sufficient for use during the live period.
II. Live Period Analysis
During the live period of investment, four additional trades were completed. As shown in
the table below, these four trades offered similar returns to those completed in the design period.

During the period of live investment, the returns ranged from relatively small negative, to
relatively small positive. However, when considering the investment horizon, the returns are
much more significant. Although considering the short investment horizon adds to the appeal of
the strategy, the variability in the returns from trade to trade makes it difficult to extrapolate the
returns over a longer time horizon.
On average, the live period offered lower returns than the design period (.184% versus .
56%). When considering both the design period and the live period, it is clear that the strategy in
question fails to earn consistent positive returns. Additionally, the strategy resulted in an
annualized Sharpe Ratio of .76 during the entire investment period, 1.07 during the investment
period, and .34 during the live period. Although these Sharpe Ratios may be highly encouraging,
these figures are inflated by the low exposure to market risk considering that this is a long-short
trading strategy. Furthermore, the returns used to calculate the Sharpe Ratio ignore the high
level of trading costs associated with pairs trading. Despite the low market exposure, it is
difficult to envision this strategy consistently earning positive profits.
III. Risks of Pairs Trading
The largest risk associated with the Pairs Trading Strategy is that it relies upon slow
diffusion of information relating to the stocks held. Since the stocks held in the strategy are
correlated, earning profit requires that as one stock moves upward or downward, the second
stock remains constant or moves in the opposite direction. However, since it is widely believed

that market are at the very least, semi-efficient, it will be difficult to choose two correlated stocks
that will respond differently to pertinent information.
CVX DailyReturnvs. OXY Daily Return
With Open Positions
0.06

0.04

12/26/14

12/19/14

12/5/14

12/12/14

11/28/14

11/21/14

11/7/14

11/14/14

10/31/14

10/24/14

10/17/14

10/3/14

10/10/14

9/26/14

9/19/14

9/5/14

9/12/14

8/29/14

8/22/14

8/8/14

8/15/14

8/1/14

7/25/14

7/18/14

7/4/14

7/11/14

6/27/14

6/20/14

6/6/14

6/13/14

5/30/14

5/23/14

5/9/14

5/16/14

5/2/14

4/25/14

4/18/14

4/4/14

4/11/14

3/28/14

3/21/14

3/7/14

3/14/14

2/28/14

2/21/14

2/7/14

2/14/14

1/31/14

1/24/14

1/17/14

1/3/14

1/10/14

0.02

-0.02

-0.04

-0.06

-0.08

CVXDailyReturn

OXYDailyReturn

Open Buy

As depicted in the figure above, when the strategy held an open position, the two stocks did not
reliably drift from each other. The stocks co-movement during the trades limited profits as two
positions were hedged against each other. For example, during the third trade, from 2/10/14 to
3/3/14, Chevron was purchased in a long position while Occidental was sold short. However, the
stocks moved in very similar directions with Occidental peaking at a much higher point that
Chevron. This movement led to negative profits as Occidentals positive price change earned
significant losses in the short position.

As previously mentioned, two additional risks associated with the pairs trading strategy
are transaction costs and the opportunity cost of not opening a position or closing a position too
early. Although this case disregards transaction costs, a total of ten trades throughout the course
of a year for only two stocks will lead to high transaction costs. When considered with the low
returns of the strategy in question, pairs trading with Chevron and Occidental is not a viable
investment opportunity. Finally, it is clear that the chosen open and close rules for this strategy
are not optimal. With more in depth analysis and information, it may be possible to develop
more successful open and close rules in order to better capture price drifts between the two
stocks. For this investment strategy, the design period only contained six months of data. A
longer period of observation would allow for more in depth analysis and the development of a
more successful investment strategy.
IV. CAPM and Fama-French
After completing a linear regression comparing the pairs trading earning to CAPM and
Fama-French Factors, it is clear that these models do not explain the pairs trading earnings.
Under CAPM, the market movement explains only 1.7% of the earnings of the strategy. Under
Fama-French, the three factors loadings only explain 1.75% of the earnings of the strategy.
However, these results are consistent with the long-short pairs trading strategy. Since Chevron
and Occidental are in the same industry and share a high correlation, purchasing one of the
stocks long and selling the other short creates a relatively market neutral investment. Although
Occidental has a lower CAPM beta than Chevron (.858 compared to 1.281), the high correlation
of the stocks during the investment period helped to offset the difference in betas as depicted by
the price movement chart below. As a result, the strategy can be explained be neither CAPM nor
Fama-French during the year of 2014.

CVX and OXY Price Movement

Chevron Adjusted Close

Occidental Petroleum Adjusted Close
However, the low R-Squared values from the CAPM and Fama-French regressions could be
explained by the non-continuous data. Since the position held in Chevron and Occidental stock
open and closed frequently, there were several lengthy periods with no returns. These periods
with no returns were considered in the regressions and thus altered the results. This could
potentially cause a selection bias that disregards returns that could have been explained under the
two models.

V. Conclusion
After analyzing the results of the Chevron-Occidental Pairs Trading strategy, it can be
concluded that it is not a viable investment strategy. It is especially concerning that the returns
during the live period were significantly lower than the returns in the design period. This fact
suggests that more thorough analysis is required in order to develop a profitable investment
strategy. It may be profitable to use Chevron and Occidental under a different set of open and
close rules, however, the returns under this strategy were simply too inconsistent to carryout this

strategy in the market especially when considering the additional risks associated with pairs
trading. The total profit of $823 is incredibly low compensation considering that a total of
$200,000 was exposed to the market ($20,000 per trade), the potential trading costs, and the high
level of activity and analysis required in the pairs trading strategy.