FE 572 Financial Engineering Project

Pairs Trading
Vedat Bayraktar Bora Akdeniz
Advisor Dr. Emrah Sener
January 15, 2010

Abstract
We test a relative value long-short investment strategy known as
Pairs Trading with daily data over the period 2006 through 2009 in
the Istanbul Stock Exchange.Stock price series are generally an inte-
grated process but a linear combination of two stock can be a synthetic
stationary process. Trading this stationary process by taking both long
and short position can be a profitable investment opportunity. 23 most
liquid stocks are matched into pairs based on cointegration and a self-
financing contrarian trading rule is used.

1 Introduction
Investment decision making using the level series is very difficult. Fi-
nancial time series are generally integrated of order one I(1). Linear
regression models may not hold when the data used is not I(0). In eco-
nomics,fundamental economic factors imply equilibrium relationships
between time series of I(1). Cointegration is a concept in economet-
rics that defines equilibrium relations between time series which are
integrated of the same order.
Nonstationary time series of the same order can be cointegrated if
it is possible to write a linear combination of them that results in a
stationary series.

β1 y1t + β2 y2t + ... + βn ynt ∼ I(0)

The cointegration vector is β = [1 − β1 − β2 ... − βn ].

y1t = β2 y2t − β3 y3t − ... − βn ynt + ut

1
where the long run equilibrium residual is stationary integrated of
order zero, ut ∼ I(0).
Statistical arbitrage depends on finding statistical anomalies be-
tween security prices. When relative mispricings between securities
are detected, then a trading algorithm can be used to exploit such
opportunities. The primary goal is to build a synthetic mean revert-
ing stationary process so that the trading orders are given when the
process reaches an extreme value.The positions are closed when the
process reverts to its long run mean value.
Detecting pairs depends on finding cointegration between price se-
ries of securities. In finance cointegration can be a high frequency or
a low frequency relationship. According to Law of One Price assets
with similar payoffs must sell at the same price, otherwise short term
relative mispricings between securities give rise to arbitrage opportu-
nities.
We choose pairs of stocks which results in a stable stationary pro-
cess using the cointegration as a statistical device. A pair of stocks can
be considered as a single synthetic asset. When the synthetic process
deviates from its mean value,expecting that the process will turn back
its mean value, a contrarian trading algorithm may lead to profit.

2 Literature Review
The first article that we will mention is: Pairs Trading, Performance
of a Relative Value Arbitrage Rule by Gatev, Goetzmann, Rouwen-
horst (2006). [1] The article tests a pairs trading strategy over a 40
years period, from 1962 up to 2002. When constructing a pairs trad-
ing strategy, the main issues to cope with are the choice of stock pairs
and the criterion for the formulation of the trading rule. Gatev et al
(2006) chooses to adopt very simple assumptions for these two issues.
They use an empirical methodology in order to choose pairs. They also
couple the stocks that have a similar price movement. Their trading
rule was simple. They open the position when the spread between two
stocks exceeds two standard deviations. On a 12 months period daily
prices of stocks have been tracked and pairs with minimum squares of
error have been formed. Authors also analyse out of sample data in
order to avoid problems related to data snooping and they reach the
similar results. As it was mentioned before authors use a standard de-
viation metric as a rule to open the position. When the spread of two
securities diverge for more than two standard deviation, the position
is open and it should be closed when the prices cross again. In the
article, two different measures of excess returns were computed. The
first one is the return on committed capital and the second one is the

2
fully-invested return. The finding is that the average monthly excess
return of the portfolio composed of the five best pairs was 1,31%.
The second article that we will mention is: The cointegration Al-
pha: Enhanced Index Tracking and Long-Short Equity Market Neu-
tral Strategies by Alexander Dimitriu (2002).[2] This article analyzes
long-short strategies in relation with index tracking, which is another
investment strategy. Dimitriu forms the pairs by using cointegration
method. In her article, Dimitriu also analyzes subjects like perfor-
mance of the strategy, returns of the long-short strategy, sharpe ra-
tios, correlation of the returns of the tracking portfolio with the index
return, and skewness and kurtosis of tracking portfolio returns.
Dimitriu tested the long-short strategy on a seven years period
and it gave all significantly positive returns except two years. There
is an interesting finding in the article by Dimitriu about long-short
strategy in terms of volatility. According to the article, long-short
strategy has a volatility that is quite lower than that of the market
index. He also tests the degree of the market neutrality of the long-
short strategy by looking at the correlation between the returns of the
long-short strategy with the returns of the market. The result is that
the long-short strategy is market neutral.
The third article is: High Frequency Pairs Trading with U.S. Trea-
sury Securities: Risks and Rewards for Hedge Funds by P. Nath
(2003).[3] This strategy is interesting because Nath uses another trad-
ing instrument for pairs trading. He uses debt securities, namely
highly liquid U.S. treasury securities instead of stocks as the instru-
ments. For the pairs selection, He considers price space rather than
returns. One peculiarity of this study is the rules that it introduces
for closing of the position. Actually, there is not one particular rule
rather there is three different conditions, which is individually suffi-
cient to close the position. First condition is the standard condition
that the other studies used, which is closing the position when the
spread comes back to its median value. This condition should be re-
sult in a profit. Second condition is related to the trading period. The
position is closed when the trading period ends. This may result in
either a profit or loss. The last one is the most interesting one and
much like a risk management tool. When the spread widens and ex-
ceeds a pre-determined certain value, position should be closed. As it
can be understood it is a stop-loss condition.
The article also mentions from the trading bound that is related to
the third condition. A wide non -trading space results in low trading
frequency, low transaction costs because there will be less trading in
such a high threshold. But if the trading do not encounter the other
two conditions and results in profit this profit will be much more than

3
a low threshold trade. The performance of the strategy is not valued in
absolute terms, rather it is compared with a benchmark composed of
equity and bonds. The result of the research is that the pairs trading
strategy outperformed this benchmark.
A comprehensive study on pairs trading is Ganapathy Vidyamurthy,
Pairs Trading, Quantitative Methods and Analysis (2004). [4] This
book comprised of three parts. The first part of the book gives some
preliminary knowledge on some important topics such as time series,
factor models, and Kalman filtering. Rest of the book is about pairs
trading in the equity markets and risk arbitrage. In the second part
of the book, Vidyamurthy gives detailed information on statistical ar-
bitrage pairs trading. It is a relative value arbitrage on two securities
based on the assumption that there is a long-run relation between the
prices of a pair of stock. The third part of the book is related to the
trading techniques and strategies associated with risk arbitrage. It
is a widely practiced arbitrage technique that include pairs trading
coming from the context of peculiar corporate events such as mergers
and acquisitions.
Vidyamurthy adopts 2-step Engle and Granger test for cointegra-
tion. In this approach, the log price of stock A is regressed against
log price of stock B. This regression is known as the cointegrating
equation:

Log(PtA ) − γ(Log(PtB ) = µ + t
γ is the cointegration coefficient,µ represents the premium in Stock
A versus Stock B. Residual series are then tested for stationarity by
Augmented Dickey Fuller (ADF) Test. After ADF test, results are
sensitive to the ordering of the variables. Vidyamurthy solved this by
using Engle and Granger test. On the cointegration equation above,
it can be seen that this is a portfolio consists of 1 unit of stock A
long, and alpha unit of stock B short. If residual series are known
to be stationary, portfolio will always revert back in the long run.
According to the trading strategy that was developed by Vidyamurthy,
trader should take a long position in the portfolio when it is below a
pre-determined amount of its mean value, and a short position when
its above its mean value. When the portfolio reverts back to the its
normal limits then position is closed and profit realised.

3 Data and Methodology

Our stock universe consists of 23 liquid stocks of Istanbul Stock Ex-
change . We have used daily closing prices adjusted for dividends and

4
AEFES Anadolu Efes
AKBNK Akbank
AKGRT Aksigorta
ARCLK Arcelik
DOHOL Dogan Holding
DYHOL Dogan Yayin Holding
ENKAI Enka Insaat
EREGL Eregli Demir Celik
GARAN Garanti Bankasi
ISCTR Is Bankasi
KCHOL Koc Holding
KOZAA Koza Madencilik
KRDMD Kardemir D
PETKM Petkim
SAHOL Sabanci Holding
SISE Sisecam
SKBNK Sekerbank
TCELL Turkcell
TEBNK Türk Ekonomi Bankasi
THYAO Türk Hava Yollari
TOASO Tofas Otomobil Fabrikasi
TUPRS Tüpras
YKBNK Yapi Kredi Bankasi

Table 1: Stock universe

5
split between January 2005 and June 2009. We have 7 pair formation
period. Each pair formation period consists of 250 days ,12 months
and following 125 days , 6 months is the corresponding trading period.
First formation period begins with first trading day of 2006 and scans
the potential pairs using the last 250 observation.In every 6 months
we choose new pairs using the last 250 observations and chosen top 2
pairs are backtested using the following 125 days.
We try to find the cointegration using Engle-Granger 2 step ap-
proach.
yt = γxt + t
First, using ordinary least squares method all price series in the stock
universe are regressed against each other using the last 250 observa-
tions as of formation time.The intercept of regression is restricted to
be zero. The Granger causality test is used to find which series lead
the relation. Accordingly ,the dependent variable in the regression is
determined.
Second, the stationarity of the residual series are tested using Aug-
mented Dickey Fuller test. If the residual series are stationary than
one can conclude that the two price series are cointegrated and coin-
tegration vector is [1 − γ]. Next step is to form a portfolio

portf olio = yt − γxt

A self financing portfolio is formed by using γ = yt /xt . The long

run relation between these two series implies that the ratio between
the two series is constant around the cointegration coefficient. The
short term deviations from the long term equilibrium can be seen as a
mispricing error process. The dynamics of the mispricing is governed
by a mean reverting stationary process . We rank pairs according to
ADF unit root test values that will result in most stable stationary
residual series.
Once the cointegrated pairs are identified one can devise new trad-
ing algorithms to exploit such market frictions. We use a trading
strategy based on the 60 day rolling mean Z score of the ratio.
P air1t
Ratiot =
P air2t
ratiot − µ60
Zratiot =
σ60
Trading signals are generated if the Z score passes 2 standard devia-
tions. Such temporary deviations are profit opportunities for a trader.
One can short the overperformed stock and buy underperformed stock
to unwind the position when the long term relation is restored.

6
 After the pairs are chosen, we test the profitability of them using
a contrarian trading strategy . The strategy relies on the rolling mean
Z score of the ratio of the pairs to get triggers to open positions.The
contrarian strategy opens position when the ratio deviates from mean
and the profit is realized at the time when the ratio reverts back to
mean value. The metric to measure the closeness to the long term
mean of the ratio is the Z score of the ratio. It is very likely that new
information reveals can cause the long term relation between the pair
of stocks to break or to put it in a different level. Therefore, one has
to use stop loss bounds to close positions whenever the z score passes
a certain level. We did not use the stop loss restrictions to see full
risks.

4 Results
In every formation period , we choose the best 2 pair looking at their
Augmented Dickey Fuller unit root test of residual series to get the
best linear combination to build a mean reverting stationary process.
During the trading period a pair can be in one of the 3 states.

Ityx = 0, closed

Ityx = 1, y = long; x = short

Ityx = −1, y = short; x = long
When the first time the position opens , the pair portfolio is formed
such that it has zero cost portf olio = yt − γxt long-short portfolio of
the same weights. The excess return to a pair is

rtyx = Ityx ∗ (rty − rtx )

Since during the 125 day trading period the positions of pairs are not
always open, the excess return on a pair is computed as
t
(1 + rtyx )
Y
Rt =
τ =1

The mean of the daily return series is 0.3% and standard devi-
ation of the daily return series is 3.26%. Average skewness is 0.18
and average kurtosis is 0.50. We have formed 7 times pairs based on
their cointegration score in our study ADF unit root test of residual
series of the linear regression equation of yt = γxt + t . During our
sample period from beginning of 2005 to June 2009 ,all pair portfolios
ended up with positive P&L. 5 in 14 pairs portfolio ended up with loss

7
 period long short adf statistic p value
1 KRDMD ARCLK -4.3846 0.0028
1 KRDMD SISE -4.0969 0.0072
2 AEFES ARCLK -3.6957 0.0244
2 AEFES KCHOL -3.6996 0.0241
3 GARAN THYAO -4.5466 0.0015
3 AEFES ENKAI -4.516 0.0017
4 AKGRT GARAN -4.666 0.001
4 TOASO THYAO -4.6191 0.0012
5 TOASO THYAO -3.9946 0.01
5 SKBNK SAHOL -4.6442 0.0011
6 PETKM SISE -4.5388 0.0016
6 SKBNK GARAN -4.5148 0.0017
7 GARAN KOZAA -4.483 0.0019
7 TEBNK DYHOL -4.2493 0.0044

Table 2: Top 2 pairs and Augmented Dickey-Fuller Test results

and 9 in 14 pairs portfolio ended up with positive cumulative return

according to our excess return calculation methodology.
Average number of transactions is 6 trade per pair. Total number
of days the position open is 65. Average cumulative excess return is
18.98%.

8
period long short trade number days of position cumulative return
1 KRDMD ARCLK 7 62 56.70%
1 KRDMD SISE 11 76 95.86%
2 AEFES ARCLK 4 51 -3.05%
2 AEFES KCHOL 8 54 45.94%
3 GARAN THYAO 8 50 40.26%
3 AEFES ENKAI 2 65 -8.43%
4 AKGRT GARAN 6 85 -12.36%
4 TOASO THYAO 6 65 19.99%
5 TOASO THYAO 6 53 19.53%
5 SKBNK SAHOL 5 98 -7.52%
6 PETKM SISE 6 91 5.72%
6 SKBNK GARAN 4 47 -12.61%
7 GARAN KOZAA 3 54 3.02%
7 TEBNK DYHOL 6 55 22.61%

Table 3: Trading characteristics

period long short mean return Stdev Skewness Kurtosis

1 KRDMD ARCLK 0.80% 3.77% 0.50 0.07
1 KRDMD SISE 0.96% 3.86% 1.08 3.37
2 AEFES ARCLK -0.01% 3.32% -0.44 0.94
2 AEFES KCHOL 0.75% 3.01% -0.12 -0.32
3 GARAN THYAO 0.73% 3.17% -0.38 -0.74
3 AEFES ENKAI -0.09% 3.07% 0.26 -0.29
4 AKGRT GARAN -0.12% 2.64% 0.13 -0.17
4 TOASO THYAO 0.31% 2.45% -0.31 -0.37
5 TOASO THYAO 0.37% 2.40% -0.25 0.21
5 SKBNK SAHOL -0.04% 2.92% -0.52 0.43
6 PETKM SISE 0.10% 2.79% 0.40 0.51
6 SKBNK GARAN -0.25% 2.71% 0.30 -0.78
7 GARAN KOZAA 0.18% 5.14% 0.20 -0.03
7 TEBNK DYHOL 0.46% 4.37% 1.70 4.19

Table 4: Pairs return characteristics

9
 long short adf statistic p value trade number days of position
TOASO TUPRS -4.3418 0.0032 6 69
SISE KCHOL -4.0363 0.0879 6 72
PETKM ARCLK -4.4822 0.0019 4 82
AEFES SKBNK -4.0523 0.0083 4 88

Table 5: Portfolio of 4 pairs

long short cumulative return mean return Stdev Skewness Kurtosis

TOASO TUPRS 12.98% 0.21% 2.42% -0.347266 -0.057846
SISE KCHOL -7.63% -0.08% 2.55% -0.599636 0.329221
PETKM ARCLK 4.61% 0.10% 2.91% -0.144413 -0.138818
AEFES SKBNK -13.50% -0.10% 3.72% -0.406672 0.336399

Table 6: Portfolio of 4 pairs results

To benchmark the profitability of the pairs trading we form a port-

folio of 4 pairs using the first 6 months of 2008 as the sample period
and compare it against the daily compounded return of IMKB 30 in-
dex during the same period . On a trading day the portfolio’s excess
return can be calculated as
n
1 X y,x,pair
rtportf olio = rt
n
pair=1

It turns out that during the first half of 2008 IMKB compounded
return is -37% and the excess compounded return of the portfolio
which consists of 4 pairs is 1%.

10
 Pair portfolio IMKB 30
0.02

−0.05
−0.10
0.00

−0.15
−0.02

−0.20
−0.25
−0.04

−0.30
−0.06

−0.35
0 10 20 30 40 50 60 70 0 20 40 60 80 100 120

Figure 1: Comparision between the excess compounded return of pair port-

folio and compounded return of IMKB 30 index

Z score of ratio P&L

3.5
2

3.0
1

2.5
2.0
0

1.5
−1

1.0
−2

0.5
−3

0.0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

Figure 2: TOASO -TUPRS

11
 Z score of ratio P&L

0.4
2

0.3
1
0

0.2
−1

0.1
−2

0.0
−3
−4

0 20 40 60 80 100 120 0 20 40 60 80 100 120

Figure 3: SISE-KCHOL

Z score of ratio P&L

3
2
1

2
0
−1

1
−2

0
−3

0 20 40 60 80 100 120 0 20 40 60 80 100 120

Figure 4: PETKM-ARCLK

12
 Z score of ratio P&L

5
4
3

3
2
2

1
1

0
−1
0

−2
0 20 40 60 80 100 120 0 20 40 60 80 100 120

Figure 5: AEFES -SKBNK

5 Conclusions
Pairs trading is the initial form of statistical arbitrage designed to ex-
ploit temporary random departures from equilibrium pricing between
two shares. It is a market neutral strategy that enables traders to
profit from virtually any market condition; uptrend, downtrend or
sidewise movement. It has been widely used in the developed markets
and has good results. We believe that investors in the emerging mar-
kets are in need of such market neutral strategies because market risks
in those countries are quite high as compared to markets of developed
countries.
In this paper, we implement a contrarian strategy which is based
on cointegration method. We use daily data of 23 most liquid stocks of
Istanbul Stock Exchange over the period 2006 through 2009. Our pairs
trading model in Istanbul Stock Exchange has been tested and gave
quite interesting results. Using a simple algorithm in order to choose
pairs and execute self-financing trading rules, we reach an average
cumulative excess return of 18.98% for top pairs portfolios.
We believe that pairs trading and, more generally, market neutral
strategies will grow a lot in importance, allowing hedge funds and
quant trading desks to cope with the risks of the volatile markets of
the emerging economies.

13
 6 Appendix

P&L cumulative return

0.7

0.5
0.6
0.5

0.4
0.4

0.3
0.3

0.2
0.2

0.1
0.1
0.0

0.0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio
4

30
3
2

20
Percent of Total
1
0

10
−1
−2
−3

0 20 40 60 80 100 120
−0.05 0.00 0.05 0.10

returnseries

Figure 6: KRDMD-ARCLK

14
 P&L cumulative return
1.2

1.0
1.0

0.8
0.8

0.6
0.6

0.4
0.4

0.2
0.2
0.0

0.0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio

50
2

40
1

Percent of Total

30
0

20
−1

10
−2

0 20 40 60 80 100 120
−0.05 0.00 0.05 0.10 0.15

returnseries

Figure 7: KRDMD-SISE

15
 P&L cumulative return

0.15
3.0
2.5

0.10
2.0

0.05
1.5

0.00
1.0
0.5

−0.05
0.0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio

40
3

30
2

Percent of Total
1

20
0

10
−1

0 20 40 60 80 100 120
−0.10 −0.05 0.00 0.05 0.10

returnseries

Figure 8: AEFES-ARCLK

16
 P&L cumulative return
25

0.4
20

0.3
15

0.2
10

0.1
5

0.0
0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio

30
3

25
2

20
1

Percent of Total

15
0

10
−1
−2

5
−3

0 20 40 60 80 100 120
−0.05 0.00 0.05

returnseries

Figure 9: AEFES-KCHOL

17
 P&L cumulative return

0.4
2.0

0.3
1.5

0.2
1.0

0.1
0.5

0.0
0.0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio
3

25
2

20
1

Percent of Total

15
0
−1

10
−2

5
−3

0 20 40 60 80 100 120
−0.05 0.00 0.05

returnseries

Figure 10: GARAN-THYAO

18
 P&L cumulative return

0.05
2

0.00
1

−0.05
−0.10
0

−0.15
−0.20
−1

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio
2

30
1
0

Percent of Total

20
−1

10
−2
−3

0 20 40 60 80 100 120
−0.05 0.00 0.05

returnseries

Figure 11: AEFES-ENKAI

19
 P&L cumulative return

0.20
5

0.15
0.10
4

0.05
3

0.00
2

−0.05
1

−0.10
0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio
3

30
2
1

20
Percent of Total
0

10
−1
−2

0 20 40 60 80 100 120
−0.05 0.00 0.05

returnseries

Figure 12: AKGRT-GARAN

20
 P&L cumulative return

0.20
2.0

0.15
0.10
1.5

0.05
1.0

0.00
0.5

−0.05
0.0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio

30
3

25
2

20
1

Percent of Total

15
0

10
−1

5
−2

0 20 40 60 80 100 120
−0.06 −0.04 −0.02 0.00 0.02 0.04 0.06

returnseries

Figure 13: TOASO-THYAO

21
 P&L cumulative return

0.20
2.0

0.15
1.5

0.10
1.0

0.05
0.5

0.00
0.0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio
2

30
1

Percent of Total
0

20
−1

10
−2
−3

0 20 40 60 80 100 120
−0.05 0.00 0.05

returnseries

Figure 14: TOASO-THYAO

22
 P&L cumulative return
1.5

0.20
0.15
1.0

0.10
0.05
0.5

0.00
−0.05
0.0

−0.10

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio

25
2

20
1

Percent of Total

15
0
−1

10
−2

5
−3

0 20 40 60 80 100 120
−0.10 −0.05 0.00 0.05

returnseries

Figure 15: SKBNK-SAHOL

23
 P&L cumulative return
2.5

0.10
2.0

0.05
1.5

0.00
−0.05
1.0

−0.10
0.5

−0.15
0.0

−0.20

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio

30
3
2

20
1

Percent of Total
0

10
−1
−2

0 20 40 60 80 100 120
−0.05 0.00 0.05

returnseries

Figure 16: PETKM-SISE

24
 P&L cumulative return
1.2

0.15
1.0

0.10
0.8

0.05
0.6

0.00
0.4

−0.05
0.2

−0.10
0.0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio
3

25
2

20
1

Percent of Total

15
0

10
−1

5
−2

0 20 40 60 80 100 120
−0.04 −0.02 0.00 0.02 0.04 0.06

returnseries

Figure 17: SKBNK-GARAN

25
 P&L cumulative return

0.2
1.5

0.1
1.0

0.0
−0.1
0.5

−0.2
0.0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio
2

30
1

Percent of Total

20
0
−1

10
−2
−3

0 20 40 60 80 100 120
−0.10 −0.05 0.00 0.05 0.10 0.15

returnseries

Figure 18: GARAN-KOZAA

26
 P&L cumulative return
0.8

0.30
0.25
0.6

0.20
0.4

0.15
0.10
0.2

0.05
0.00
0.0

0 20 40 60 80 100 120 0 20 40 60 80 100 120

return
Z score of ratio

40
2

30
1

Percent of Total
0

20
−1

10
−2

0
−3

0 20 40 60 80 100 120
−0.05 0.00 0.05 0.10 0.15 0.20

returnseries

Figure 19: TEBNK-DYHOL

27
References
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