Lessons Learnt From A Real Pairs Trading Signal On The Requirements To Generate Real Alpha In A Competitive Market

Introduction

It is generally understood that signals decay, but the mechanisms that lead to their decay is seldom well understood. Today, I want to show you a real trading signal that every systematic long short team ran from 2010 to… present day, and explain to you exactly how alpha compression happens, and what are the implications of this compression when YOU are looking to generate alpha.

Yes, it’s the infamous pairs-trading signal.

Understanding the way in which the trade has decayed is supremely important for systematic traders, because this is a signal that is grounded in strong economic rationale: there are instruments (stocks) that are similar businesses and are therefore expected to share very similar price movements (since these price movements will have the same economic/industry/subindustry/business line drivers), hence, the idea is that whenever these price movements STOP being similar (temporarily), you can bet that they will eventually become similar again, therefore earning the spread from the dislocation closing.

For all intents and purposes - it should always “exists”, but the data doesn’t seem to be supporting it. Why?