Importance of trade execution

The execution of a Pair Trade is critical in determining its profitability. Given that the trader is only looking for convergence of between 3-4% for each trade, “slippage” is a critical factor in the success of the trade. For example, assuming that your software generates a buy signal on SLB at $20.05 and a corresponding sell signal on CAB at $19.55, both legs must be filled in order for the Pair Trade to work and cannot be left exposed.

Provided that the trader enters SLB at $20.50 and CAB at $19.30, the “slippage” on execution would reduce the profitability of the trade. The trader should only take the trade if the “slippage” is less than 0.25% and hence, must be minimised. Accordingly, real-time analysis, execution and live data are critical inputs in the success of a Pair Trade. 

Liquidity also plays an important role in the execution of a trade. If there is not enough liquidity (i.e. the market is thin and there aren’t enough buyers and sellers on both sides in the corresponding market depth of the security), the slippage would be magnified and hence, the Pair Trade would not work. For that reason, it is important that the trader considers the liquidity of the stock and ensures that market depth is strong.