What would be the problem with this pairs trading allocation scheme?

Question

I am new to pairs trading, and I have come up with an idea of how to allocate capital between the long and short leg of a pairs trade. I feel that there is a problem with it, and I want to figure out what I'm missing.

Let's say I have stock A and B, and I have a trading signal that it's time to enter a long/short pairs trade to trade the spread. Rather than doing a 50/50 split between the long/short, my idea is to allocate in proportion to the price variances.

For example, if stock A's price varies wildly and stock B's price doesn't, my logic is that I would want to put more of my capital in the position associated with stock A since it tends to move more and presumably, all else equal, its percent change would be larger than stock B's as the trade moves to convergence.

The immediate potential issue I see here is that this would make my overall trade NOT market neutral (as in, not "dollar neutral") since the bets are asymmetric. Does this mean that, on average, I would lose out? I can't help but feel like my initial logic is solid, though.

I would greatly appreciate any thoughts/perspective on this.

Answer 1

Most volatility weighted strategies I have seen take the opposite approach. The less volatile asset is weighted more to make the overall portfolio volatility neutral. The rationale being that you are attempting to benefit from a narrowing or widening of a spread and by attempting to make the volatilities of your long and shorts being equal, you are negating the effects of one leg of your trade being more volatile than the other. As you correctly surmised, volatility weighting would unlikely be dollar neutral. They could be both a credit or debit net position, in which case you would either net short or net long from a dollar weighted basis.

There have been other strategies that utilize volatility as a basis for weighting. One of the most in vogue strategies are the "risk parity" strategies. These strategies make an implicit assumption that volatility is the primary risk of a position and that to evaluate two positions, one should make the volatilities equal. With the volatilities equal, the investment opportunity with the higher return would be the better investment. They further rationalize this approach of utilizing volatility as a basis of allocation in that volatility prediction is more accurate than returns prediction.

Many other hedge fund strategies also are implicitly taking a volatility adjusted approach to capital allocation in that they are usually leveraging up lower volatility (strategies to meet return targets.