How Some Bankers Made a Million by Trading Just Two Securities

We study a pair tradingstrategy that utilizes short-term return reversals in the stock market. Using U.S. data, we show that returns to our pair tradingstrategy exceed reasonable estimates for transaction costs. The strategy also generates positivealpha when controlling for the standard risk factors. Second, using transaction level data from Finland, focusing on a popular pair, we provide evidence that these kinds of pair tradingreturns are compensation from providing liquidity. On the days when the expected returnsto our pair tradingstrategy are the highest, the trading volume is abnormally high and, judging from active brokers’ net trades, nearly 45% of all brokers (or their customers) engagein pair tradingin accordance with our trading strategy. These brokers are mainly counterpartiesto few brokers that trade large quantities of stocks inconsistent with our strategy.