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**Nikos S. Thomaidis, PhD1
**

Dept. of Economics, Aristotle University of Thessaloniki, GREECE Dept. of Financial Engineering & Management University of the Aegean, GREECE email: nthomaid@fme.aegean.gr Dept URL: http://labs.fme.aegean.gr/decision/ Personal web site: http://users.otenet.gr/~ ntho18

**in collaboration with Nicholas Kondakis, Kepler Asset Management LLC, NY (http://www.keplerfunds.com)
**

Nikos S. Thomaidis, PhD Statistical arbitrage and pairs trading

1

Outline

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

Outline

What is pairs trading?

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

Outline What is pairs trading? Developing a pairs trading system from scratch Nikos S. Thomaidis. PhD Statistical arbitrage and pairs trading .

PhD Statistical arbitrage and pairs trading . Thomaidis.Outline What is pairs trading? Developing a pairs trading system from scratch Empirical study: statistical arbitrage between Dow Jones Industrial Average (DJIA) stocks Nikos S.

PhD Statistical arbitrage and pairs trading . Thomaidis.Outline What is pairs trading? Developing a pairs trading system from scratch Empirical study: statistical arbitrage between Dow Jones Industrial Average (DJIA) stocks Conclusions Nikos S.

Outline What is pairs trading? Developing a pairs trading system from scratch Empirical study: statistical arbitrage between Dow Jones Industrial Average (DJIA) stocks Conclusions Trading risks Nikos S. Thomaidis. PhD Statistical arbitrage and pairs trading .

PhD Statistical arbitrage and pairs trading .Outline What is pairs trading? Developing a pairs trading system from scratch Empirical study: statistical arbitrage between Dow Jones Industrial Average (DJIA) stocks Conclusions Trading risks Opportunities Nikos S. Thomaidis.

Outline What is pairs trading? Developing a pairs trading system from scratch Empirical study: statistical arbitrage between Dow Jones Industrial Average (DJIA) stocks Conclusions Trading risks Opportunities Future challenges Nikos S. Thomaidis. PhD Statistical arbitrage and pairs trading .

PhD Statistical arbitrage and pairs trading .Pairs trading: the history 2 See [Pole. Thomaidis. Vidyamurthy. Nikos S.php?f=3&t=14 for interesting facts and information on the history of the topic. 2004] and http://www. 2007.com/forum/viewtopic.pairtradefinder.

Vidyamurthy. 2007.pairtradefinder.com/forum/viewtopic.php?f=3&t=14 for interesting facts and information on the history of the topic. PhD Statistical arbitrage and pairs trading . Nikos S. Thomaidis. 2 See [Pole.Pairs trading: the history Pairs trading has at least twenty-ﬁve years of history on Wall Street. 2004] and http://www.

PhD Statistical arbitrage and pairs trading . 2007. Morgan Stanley . Nikos S.pairtradefinder. Already in the mid 80’s. Thomaidis. Vidyamurthy. 2004] and http://www.and perhaps other investment companies .have started developing programs that could buy/sell stocks in pair combinations2 .Pairs trading: the history Pairs trading has at least twenty-ﬁve years of history on Wall Street.com/forum/viewtopic. 2 See [Pole.php?f=3&t=14 for interesting facts and information on the history of the topic.

Already in the mid 80’s. Morgan Stanley . 2007. Thomaidis.php?f=3&t=14 for interesting facts and information on the history of the topic.pairtradefinder.and perhaps other investment companies .com/forum/viewtopic. PhD Statistical arbitrage and pairs trading . Vidyamurthy. executing trades through an automated computer-based system). 2 See [Pole. Nikos S. These strategies were strongly quantitative (generating trading rules using statistical/mathematical techniques.Pairs trading: the history Pairs trading has at least twenty-ﬁve years of history on Wall Street.have started developing programs that could buy/sell stocks in pair combinations2 . 2004] and http://www.

Cross-disciplinary work (mathematicians.com/forum/viewtopic. computer scientists.pairtradefinder. 2007.have started developing programs that could buy/sell stocks in pair combinations2 . Already in the mid 80’s.and perhaps other investment companies . statisticians. Morgan Stanley . PhD Statistical arbitrage and pairs trading . These strategies were strongly quantitative (generating trading rules using statistical/mathematical techniques.php?f=3&t=14 for interesting facts and information on the history of the topic. executing trades through an automated computer-based system). ﬁnance experts). physicists. Nikos S. Thomaidis. Vidyamurthy. 2004] and http://www.Pairs trading: the history Pairs trading has at least twenty-ﬁve years of history on Wall Street. 2 See [Pole.

Pairs trading: main idea Nikos S. PhD Statistical arbitrage and pairs trading . Thomaidis.

Thomaidis. PhD Statistical arbitrage and pairs trading . in anticipation of making money when the inequality is corrected in the future [Whistler. 2004] Nikos S.Pairs trading: main idea Capitalise on market imbalances between two or more securities.

Thomaidis. 2004] Find two securities that have moved together over the near past Nikos S. PhD Statistical arbitrage and pairs trading . in anticipation of making money when the inequality is corrected in the future [Whistler.Pairs trading: main idea Capitalise on market imbalances between two or more securities.

Pairs trading: main idea Capitalise on market imbalances between two or more securities. short the overvalued and buy the undervalued one Nikos S. 2004] Find two securities that have moved together over the near past When the distance (spread) between their prices goes above a threshold. PhD Statistical arbitrage and pairs trading . Thomaidis. in anticipation of making money when the inequality is corrected in the future [Whistler.

short the overvalued and buy the undervalued one If securities return to the historical norm. PhD Statistical arbitrage and pairs trading . Thomaidis.Pairs trading: main idea Capitalise on market imbalances between two or more securities. 2004] Find two securities that have moved together over the near past When the distance (spread) between their prices goes above a threshold. prices will converge in the near future and you will end up with a proﬁt Nikos S. in anticipation of making money when the inequality is corrected in the future [Whistler.

Thomaidis. PhD Statistical arbitrage and pairs trading .So what is pairs trading? Nikos S.

PhD Statistical arbitrage and pairs trading .So what is pairs trading? a market-neutral trading strategy: generates proﬁt under all market conditions (uptrend. Thomaidis. downtrend. or sideways movements) Nikos S.

Thomaidis.So what is pairs trading? a market-neutral trading strategy: generates proﬁt under all market conditions (uptrend. or sideways movements) a statistical arbitrage trading strategy: proﬁt from temporal mispricings of an asset relative to its fundamental value. Nikos S. PhD Statistical arbitrage and pairs trading . downtrend.

downtrend.So what is pairs trading? a market-neutral trading strategy: generates proﬁt under all market conditions (uptrend. so that the investor should be little aﬀected by sector-wide events Nikos S. Thomaidis. PhD Statistical arbitrage and pairs trading . a long/short equity strategy: long positions are hedged with short positions in the same or related sectors. or sideways movements) a statistical arbitrage trading strategy: proﬁt from temporal mispricings of an asset relative to its fundamental value.

or sideways movements) a statistical arbitrage trading strategy: proﬁt from temporal mispricings of an asset relative to its fundamental value.So what is pairs trading? a market-neutral trading strategy: generates proﬁt under all market conditions (uptrend. Nikos S. a long/short equity strategy: long positions are hedged with short positions in the same or related sectors. downtrend. so that the investor should be little aﬀected by sector-wide events relative-value trading. PhD Statistical arbitrage and pairs trading . Thomaidis.

Nikos S. Thomaidis.So what is pairs trading? a market-neutral trading strategy: generates proﬁt under all market conditions (uptrend. or sideways movements) a statistical arbitrage trading strategy: proﬁt from temporal mispricings of an asset relative to its fundamental value. downtrend. so that the investor should be little aﬀected by sector-wide events relative-value trading. convergence trading. a long/short equity strategy: long positions are hedged with short positions in the same or related sectors. PhD Statistical arbitrage and pairs trading .

and so on.So what is pairs trading? a market-neutral trading strategy: generates proﬁt under all market conditions (uptrend. so that the investor should be little aﬀected by sector-wide events relative-value trading. convergence trading. Thomaidis... PhD Statistical arbitrage and pairs trading . downtrend. a long/short equity strategy: long positions are hedged with short positions in the same or related sectors. Nikos S. or sideways movements) a statistical arbitrage trading strategy: proﬁt from temporal mispricings of an asset relative to its fundamental value.

so that the investor should be little aﬀected by sector-wide events relative-value trading... Thomaidis. or sideways movements) a statistical arbitrage trading strategy: proﬁt from temporal mispricings of an asset relative to its fundamental value. PhD Statistical arbitrage and pairs trading .So what is pairs trading? a market-neutral trading strategy: generates proﬁt under all market conditions (uptrend. Pairs trading → group trading Nikos S. a long/short equity strategy: long positions are hedged with short positions in the same or related sectors. and so on. convergence trading. downtrend.

PhD Statistical arbitrage and pairs trading .Why pairs work: the drunk and his dog A humorous metaphor adapted from [Murray. Nikos S. 1994] to the context of pairs trading. Thomaidis.

unit-root. Thomaidis.Why pairs work: the drunk and his dog A humorous metaphor adapted from [Murray. A drunk customer sets out from the pub (“Gin Palace”) and starts wandering in the streets (random walk. PhD Statistical arbitrage and pairs trading . 1994] to the context of pairs trading. integrated stochastic process) Nikos S.

after all. 1994] to the context of pairs trading. Thomaidis. integrated stochastic process) The accompanying dog thinks: “I can’t let him get too far oﬀ. A drunk customer sets out from the pub (“Gin Palace”) and starts wandering in the streets (random walk. my role is to protect him!” Nikos S. PhD Statistical arbitrage and pairs trading .Why pairs work: the drunk and his dog A humorous metaphor adapted from [Murray. unit-root.

Thomaidis. the dog assesses how far the drunk is and moves accordingly to close the gap Nikos S. A drunk customer sets out from the pub (“Gin Palace”) and starts wandering in the streets (random walk. my role is to protect him!” So. 1994] to the context of pairs trading.Why pairs work: the drunk and his dog A humorous metaphor adapted from [Murray. PhD Statistical arbitrage and pairs trading . integrated stochastic process) The accompanying dog thinks: “I can’t let him get too far oﬀ. unit-root. after all.

PhD Statistical arbitrage and pairs trading .The drunk and his dog: the story continues Nikos S. Thomaidis.

PhD Statistical arbitrage and pairs trading .The drunk and his dog: the story continues Rory and Gary. Thomaidis. look outside the pub’s window and bet on the drunk’s and the dog’ s position Nikos S. two regular customers.

lack of predictability) Nikos S. two regular customers. PhD Statistical arbitrage and pairs trading .The drunk and his dog: the story continues Rory and Gary. Thomaidis. look outside the pub’s window and bet on the drunk’s and the dog’ s position They observe the drunk and the dog individually but their course looks no diﬀerent than a random walk (growing variance in location.

lack of predictability) Suddenly. PhD Statistical arbitrage and pairs trading . look outside the pub’s window and bet on the drunk’s and the dog’ s position They observe the drunk and the dog individually but their course looks no diﬀerent than a random walk (growing variance in location. Gary throws the idea: “Well. Thomaidis. two regular customers.The drunk and his dog: the story continues Rory and Gary. the dog must not be far away” Nikos S. it’s all a matter of ﬁnding the drunk.

The drunk and his dog: the story continues Rory and Gary. lack of predictability) Suddenly. two regular customers. PhD Statistical arbitrage and pairs trading . it’s all a matter of ﬁnding the drunk. Gary throws the idea: “Well. the dog must not be far away” He is right because the gap between the two fellows should occasionally open and close but never being out of control (co-integration) Nikos S. look outside the pub’s window and bet on the drunk’s and the dog’ s position They observe the drunk and the dog individually but their course looks no diﬀerent than a random walk (growing variance in location. Thomaidis.

lack of predictability) Suddenly. Gary throws the idea: “Well. the dog must not be far away” He is right because the gap between the two fellows should occasionally open and close but never being out of control (co-integration) Rory and Gary eventually agree to play the following game: Nikos S. PhD Statistical arbitrage and pairs trading . Thomaidis. look outside the pub’s window and bet on the drunk’s and the dog’ s position They observe the drunk and the dog individually but their course looks no diﬀerent than a random walk (growing variance in location. two regular customers.The drunk and his dog: the story continues Rory and Gary. it’s all a matter of ﬁnding the drunk.

The drunk and his dog: the story continues Rory and Gary. the dog must not be far away” He is right because the gap between the two fellows should occasionally open and close but never being out of control (co-integration) Rory and Gary eventually agree to play the following game: “Why not betting on their relative distance rather than their absolute positions?” Nikos S. lack of predictability) Suddenly. PhD Statistical arbitrage and pairs trading . look outside the pub’s window and bet on the drunk’s and the dog’ s position They observe the drunk and the dog individually but their course looks no diﬀerent than a random walk (growing variance in location. it’s all a matter of ﬁnding the drunk. two regular customers. Thomaidis. Gary throws the idea: “Well.

85 0.65 Mar93 Dec95 Sep98 May01 Feb04 Nov06 Aug09 May12 GT HPQ Figure 1: Normalised price paths of Goodyear (GT) and Hewlett Packard (HPQ). PhD Statistical arbitrage and pairs trading .75 0.8 0.9 0.An actual traded pair 1.7 0. Nikos S. Thomaidis.95 0.05 1 0.

Why pairs trading is successful? A behavioural-ﬁnance explanation: New information is rapidly impounded in stock prices through investment activity (market eﬃciency) Stock price movements reﬂect all publicly available information (future earnings prospects. political events) Two securities that are close substitutes for each other respond similarly to incoming news Overreaction and herding behaviour of uninformed and “noisy” investors often drives prices apart But. corporate news. PhD Statistical arbitrage and pairs trading . Thomaidis. any deviation is temporary and rational traders are expected to close the “gaps” in the long run Nikos S.

Basic steps in developing a pairs trading system

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

**Basic steps in developing a pairs trading system
**

Group formation

Pick closely-related stocks and detect stable relative price relationships

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

**Basic steps in developing a pairs trading system
**

Group formation

Pick closely-related stocks and detect stable relative price relationships

Group trading

Determine the direction of the relationship (divergence, re-convergence) Find suitable trade-open and trade-close points

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

re-convergence) Find suitable trade-open and trade-close points Risk management Minimise divergence risk (the gap between stocks further widens) Fine-tune parameters with respect to a trading performance criterion (maximise expected return. Thomaidis. PhD Statistical arbitrage and pairs trading . maximise a reward-risk ratio. etc) Nikos S.Basic steps in developing a pairs trading system Group formation Pick closely-related stocks and detect stable relative price relationships Group trading Determine the direction of the relationship (divergence.

PhD Statistical arbitrage and pairs trading .Group formation strategy Nikos S. Thomaidis.

Correlation coeﬃcient 0. 3.76 0. Pair Pair 3 1 2 3 4 19 20 Stock Stock Stock Stock .Maximum price correlation (MPC) 1 2 Choose a charting time-frame Compute the correlation of historical price series. 4}...g.81 0. Stock Stock 1 1 2 8 13 26 Stock Stock Stock Stock . PhD Statistical arbitrage and pairs trading 4 .87 0.... e. 10} Nikos S. {8.17 Pair Pair Pair Pair . Stock Stock 3 5 4 10 26 27 Pick the top 20% of pairs (i.26 0. {2.e 4 pairs) with the highest historical correlation Formed groups: {1.91 0.. 5}. Thomaidis.

2005] Construct a cumulative total return index for each stock over the formation period t crt.i is the t-period’s return on stock i .i ).i − cr . Thomaidis.pick the top a% of the list for group formation Nikos S. j) ≡ |cr .j )2 Rank stock pairs based on increasing values of d .Minimum normalised price distance (MNPD) Popular in literature [Gatev et al. ....i = 1 and rt.j | ≡ t=1 (crt.i ≡ (1 + rτ. 2006. 2. Euclidean distance T d(i ..i − crt. Andrade et al. PhD Statistical arbitrage and pairs trading . t = 1.g.. Introduce a “distance” measure: e. T τ =1 where cr0.

. PtN ) satisfy the relationship Pt1 = c + β2 Pt2 + · · · + βn PtN + Zt where Zt is the mispricing index (captures temporal deviations from equilibrium) The coeﬃcients of the relationship can be estimated using Ordinary Least Squares (OLS) Nikos S. Pt2 . Vidyamurthy. Burgess.Identify stationary relationships (1/5) Applying techniques from co-integration analysis [Engle and Granger. . . 2004] Assume that a group of stocks with price vector Pt = (Pt1 . PhD Statistical arbitrage and pairs trading . 2000. . 1987. Thomaidis.

.β3 ··· ··· N ˆ . ˆ the OLS estimate of c) Nikos S. −βN ) is by construction mean-reverting (ﬂuctuates around c . . −β3 . . where ˆ ˆ ˆ ˆ β ≡ (1. .Identify stationary relationships (2/5) Construct a portfolio as follows: Stocks Positions 1 +1 2 ˆ -β2 3 ˆ . PhD Statistical arbitrage and pairs trading . −β2 . Thomaidis.βN ˆ where βi is the OLS estimate of βi and “+” (“-”) indicates a long (short) position ˆ ˆ The portfolio value Zt ≡ β · Pt .

PhD Statistical arbitrage and pairs trading .Identify relationships with OLS (3/5) 15 Stock 1 Stock 2 Prices 10 5 0 50 100 150 Group formation sample 200 250 Nikos S. Thomaidis.

5 Stock 2 13 12. PhD Statistical arbitrage and pairs trading .5 12 11.5 11 5.5 14 13. Thomaidis.5 6 6.5 Nikos S.843 − 0.5 negative mispricing Equilibrium relationship: −−−−−−−−−−−−−−−−−− P2 = 14.257 P1 actual price pairs equilibrium relationship positive mispricing 8 8.5 7 Stock 1 7.Identify relationships with OLS (4/5) 14.

5 15 14. PhD Statistical arbitrage and pairs trading .Identify relationships with OLS (5/5) 16.5 13 0 Zt=P2 + 0.5 16 Relative mispricing 15. Thomaidis.257 P1 Stock 2 underpriced relative to Stock 1 Stock 2 overpriced relative to Stock 1 50 100 150 Group formation sample 200 250 Nikos S.5 14 13.

etc These place restrictions on the beta coeﬃcients (stock holdings) → restricted OLS estimation Nikos S. Thomaidis. PhD Statistical arbitrage and pairs trading .Conditions for meaningful capital allocations The average capital invested on each stock (average price × number of shares) must be below 80% and above 5% The ratio between the maximum and the minimum number of shares held from each asset should not exceed 10.

Group trading Nikos S. PhD Statistical arbitrage and pairs trading . Thomaidis.

2012] Nikos S.. Thomaidis and Kondakis. 2006.Trading strategya a See also [Thomaidis et al. Thomaidis. PhD Statistical arbitrage and pairs trading .

α ˆtH.. PhD Statistical arbitrage and pairs trading .α Sell the portfolio.α is a 100 × (1 − 2α)% conﬁdence “envelope” on the value of the mispricing. Nikos S. when the mispricing index diverges by a certain threshold ˆ Buy the portfolio.Trading strategya a See also [Thomaidis et al. ZtH. Thomaidis and Kondakis. Thomaidis. 2012] Open a position in a group. 2006.α . if Zt > Z ˆ ˆ where ZtL. over the trading period. if Zt < ZtL.

if Zt < ZtL.α ˆtH.Trading strategya a See also [Thomaidis et al. Thomaidis and Kondakis.α Sell the portfolio.α . when the mispricing index diverges by a certain threshold ˆ Buy the portfolio. 2006. 2012] Open a position in a group. Thomaidis. Unwind the position after h periods of time Nikos S. ZtH. over the trading period. if Zt > Z ˆ ˆ where ZtL.α is a 100 × (1 − 2α)% conﬁdence “envelope” on the value of the mispricing. PhD Statistical arbitrage and pairs trading ..

2006..α is a 100 × (1 − 2α)% conﬁdence “envelope” on the value of the mispricing. Unwind the position after h periods of time unless Nikos S.α ˆtH. PhD Statistical arbitrage and pairs trading .α Sell the portfolio. if Zt < ZtL. 2012] Open a position in a group. if Zt > Z ˆ ˆ where ZtL. Thomaidis and Kondakis. over the trading period.α .Trading strategya a See also [Thomaidis et al. when the mispricing index diverges by a certain threshold ˆ Buy the portfolio. Thomaidis. ZtH.

.Trading strategya a See also [Thomaidis et al.α .α is a 100 × (1 − 2α)% conﬁdence “envelope” on the value of the mispricing. if Zt < ZtL. Thomaidis and Kondakis. if Zt > Z ˆ ˆ where ZtL. over the trading period. Unwind the position after h periods of time unless the mispricing index continues to diverge (does not cross up the lower bound or cross down the upper bound) Nikos S.α Sell the portfolio. 2006. ZtH. when the mispricing index diverges by a certain threshold ˆ Buy the portfolio. PhD Statistical arbitrage and pairs trading . Thomaidis. 2012] Open a position in a group.α ˆtH.

Thomaidis. 2006.Trading strategya a See also [Thomaidis et al. Thomaidis and Kondakis.α . if Zt > Z ˆ ˆ where ZtL. if Zt < ZtL.α Sell the portfolio.. 2012] Open a position in a group. PhD Statistical arbitrage and pairs trading .α is a 100 × (1 − 2α)% conﬁdence “envelope” on the value of the mispricing.α ˆtH. Unwind the position after h periods of time unless the mispricing index continues to diverge (does not cross up the lower bound or cross down the upper bound) Close the position earlier and open a new position if the synthetic re-converges and crosses the opposite bound Nikos S. when the mispricing index diverges by a certain threshold ˆ Buy the portfolio. over the trading period. ZtH.

α is of the form c ± zα σZ . 2012] Open a position in a group.. Thomaidis and Kondakis. 2006. ZtH. Thomaidis. Nikos S. σZ are the ˆ ˆ ˆ ˆ sample mean and standard deviation of the synthetic value over the formation period and zα is the critical value from a N(0.α .α ˆtH.α .α is a 100 × (1 − 2α)% conﬁdence “envelope” on the value of the mispricing. if Zt > Z ˆ ˆ where ZtL.Trading strategya a See also [Thomaidis et al. where c . ZtH. when the mispricing index diverges by a certain threshold ˆ Buy the portfolio. 1) distribution. if Zt < ZtL. PhD Statistical arbitrage and pairs trading .α Sell the portfolio. Unwind the position after h periods of time unless the mispricing index continues to diverge (does not cross up the lower bound or cross down the upper bound) Close the position earlier and open a new position if the synthetic re-converges and crosses the opposite bound ˆ ˆ ZtL. over the trading period.

PhD Statistical arbitrage and pairs trading Price ($) . Thomaidis. Trading parameters: HOP = 1day .06 PHPQ 20 40 Mispricing index Confidence bounds 80 Long positions 100 Short positions 120 60 Trading period Figure 3: Mispricing index: Zt = PGT − 1.06PHPQ .Example: trading a group of 2 stocks (1/2) GOODYEAR (GT) vs HEWLETT PACKARD (HPQ) 42 40 Price ($) 38 36 34 0 GT HPQ 20 18 16 14 20 40 60 Trading period 80 100 120 12 24 23 Mispricing 22 21 20 19 18 0 Zt=PGT −1. Nikos S. αL = 10%. αH = 5% .

PhD Statistical arbitrage and pairs trading . Nikos S. Thomaidis. αL = 10%. αH = 5% .Example: trading a group of 2 stocks (2/2) 24 23 Mispricing 22 21 20 19 18 0 20 40 Mispricing index 60 Trading period Confidence bounds 80 Long positions 100 Short positions 120 8 Cumulative return (%) 6 4 2 0 −2 0 20 40 60 Trading period 80 100 120 Figure 4: HOP=1 day.

4 1. PhD Statistical arbitrage and pairs trading . Nikos S.Example: trading a group of 4 stocks (1/2) 1.6 Normalised prices 1. Thomaidis.2 1 0. αL = 20%. αH = 20% .8 0 0 −1 −2 −3 −4 0 AA AXP CAT IBM Long positions Short positions 50 100 Trading period 150 200 250 Mispricing Mispricing index 50 Confidence bounds 100 Long positions Trading period Short positions 150 200 250 Figure 5: HOP=1 day.

αL = 20%.Example: trading a group of 4 stocks(2/2) 0 −1 Mispricing −2 −3 Mispricing index −4 0 30 Cumulative return (%) 20 10 0 50 100 Trading period Confidence bounds Long positions 150 Short positions 200 250 −10 0 50 100 Trading period 150 200 250 Figure 6: HOP=1 day. αH = 20% . Thomaidis. PhD Statistical arbitrage and pairs trading . Nikos S.

downside std. std.System performance measurement Are there truly successful rules that deliver consistent return or risk-adjusted return? Performance indicators (mean. information ratio (IR). PhD Statistical arbitrage and pairs trading . Thomaidis. downside IR) How does performance vary with diﬀerent market conditions? Can high returns be explained by speciﬁc exposure to industry and other systematic risk factors? Are we capturing other patterns of stock movements (price reversals)? How skillful is our system in terms of picking the right pairs/ﬁnding price equilibriums? How able is our system to early detect price divergence and predict re-convergence points? Do our strategies require too much trading? Do our strategies maintain their performance ranking over time? Do the best remain the best and the worst remain the worst? Nikos S.

20. 10. PhD Statistical arbitrage and pairs trading . αH ∈ {1. 125. 5.Experimental set-up Daily prices of 30 stock members of Dow Jones Industrial Average (DJIA) index (with dividends reinvested) Sample period: 3 Jan 1994 to 24 Feb 2010 Group formation: Window length (WL) {125. 40}% A total of 3. 5. 10. 250} days Screen out DJIA stocks with one or more days without a trade (identify relatively liquid stocks and facilitate pairs formation) Choose matching stocks based on MNPD and MPC criteria (form groups from the 5%. 150} days Hold-out period (HOP): {1. 25} days αL . 600 parametrisations Nikos S. Thomaidis. 20% or 50% highest-ranking pairs of the list) Trading strategy Trading period: subsequent {50.

Thomaidis. HOP: Position holdout period. TP: Trading period. Nikos S.5% 25 40 1 Best strategy (IR) 125 150 MPC .20% 25 10 1 3 WL: Length of moving window.Best trading strategies Design parameters3 WL TP GFC HOP αL (%) αH (%) Best strategy (Mean return) Sample: 1994-2010 125 150 MPC . PhD Statistical arbitrage and pairs trading . GFC: Group formation criterion.

Nikos S.27 0. Thomaidis.78 5.48 16. PhD Statistical arbitrage and pairs trading .75 6.54 0.00 23.Performance of best trading strategies Trading measures Mean(%) Stdev(%) DStdev(%) IR DIR Best strategy Best strategy (IR) Buy & hold portfolio (Mean return) Sample: 1994-2010 (784 observations) 11.36 Table 1: Average weekly performance (annualised measures).44 0.94 22.65 7.78 0.49 1.92 26.44 9.20 0.

PhD Statistical arbitrage and pairs trading .Portfolios of good strategies Nikos S. Thomaidis.

PhD Statistical arbitrage and pairs trading . Thomaidis.Portfolios of good strategies No investor would risk putting all his money in a single strategy Nikos S.

PhD Statistical arbitrage and pairs trading .Portfolios of good strategies No investor would risk putting all his money in a single strategy Mixing-up diﬀerent parameter combinations Nikos S. Thomaidis.

PhD Statistical arbitrage and pairs trading . Thomaidis.Portfolios of good strategies No investor would risk putting all his money in a single strategy Mixing-up diﬀerent parameter combinations “Bundles” of trading strategies: “Distribute your capital evenly between the top-a % of the parameterisations” Nikos S.

65 5.42 4.49 0.93 1.63 3.54 0.Mean return Strategies Mean(%) Stdev(%) DStdev(%) IR DIR Percentage of trading strategies 100 90 65 35 10 1.00 23.05 0.54 0.26 2.98 2.00 6.92 26.39 Best Buy & strategy hold 11. Thomaidis.16 1.44 0.15 2.75 16.69 4.27 0.71 0.88 1.68 0.19 2.65 3.44 22.48 3.46 3.36 Table 2: Average weekly performance on the full sample period (annualised measures).12 1.10 2.19 2.16 2. Nikos S. PhD Statistical arbitrage and pairs trading .63 2.64 6.Performance of mixtures .

78 5.64 2.12 1. Nikos S.19 2. Thomaidis.42 4.78 0.65 4.68 0.22 1.55 0.09 2.98 2.93 1. PhD Statistical arbitrage and pairs trading .93 3.20 0.43 5.54 0.00 6.37 0.94 22.46 3.Information ratio (1/2) Strategies Mean(%) Stdev(%) DStdev(%) IR DIR Percentage of trading strategies 100 90 65 35 10 1.65 3.31 2.36 Table 3: Average weekly performance on the full sample period (annualised measures).66 3.32 Best Buy & strategy hold 7.88 1.48 16.92 9.63 3.27 1.54 0.26 2.03 2.18 2.Performance of mixtures .

Thomaidis.Information ratio (2/2) IR−maximising strategies 350 300 250 Cumulative return (%) 200 150 100 50 0 −50 top−100 top−90 top−65 top−35 top−10 best strategy buy & hold Dec95 Sep98 May01 Feb04 Nov06 Aug09 Nikos S. PhD Statistical arbitrage and pairs trading .Performance of mixtures .

PhD Statistical arbitrage and pairs trading . Thomaidis. Nikos S.Systematic risk exposure 200 Market SMB HML Top−10%(IR) 150 cumulative return (%) 100 50 0 −50 Mar93 Dec95 Sep98 May01 Feb04 Nov06 Aug09 May12 Figure 7: Historical performance of the top-10% portfolio (IR) and systematic factors of risk.

06) -0.03 (0.00 (0.83) -0.04 (0.03) 0.00 (0.01 (0.36) of trading 65 0.00 (0.00 (0.00) -0.15 (0.03 (0.03 (0.14) 0.36) 0.03 (0.00) -0. Nikos S.03) 0.04 (0.01) -0.04) -0.00) 0.00 (0.09) -0.82) -0.20) 0.00) -0.00 (0.09 (0.03 (0.00) 0.89) -0.04 (0.Systematic risk exposure Strategies Alpha MKT SMB HML MOM LTR STR Consumer Durables Manufacturing HiTec Health Other 100 0.02 (0.02 (0.95) 0.50) -0.04) 0.00 (0.81) 0.15 (0.40) -0.82) -0.00 (0.49) -0.00 (0.04 (0.03) 0.00) -0.04) -0.00 (0.03 (0.12) -0.56) 0. PhD Statistical arbitrage and pairs trading .01) -0.69) 0.04 (0.52) 0. Thomaidis.10) -0.87) 0.09) 0.00 (0.11 (0.02 (0.96) 0.00) -0.02 (0.00) -0.14) 0.00) 0.55) 10 0.03 (0.08) 0.89) -0.04 (0.15 (0.00) 0.03 (0.04) 0.98) -0.00) 0.00) -0.01 (0.13 (0.01 (0.02 (0.03 (0.00) 0.01) 0.44) strategies 35 0.10) 0.30) 0.88) 0.03 (0.01 (0.03 (0.00 (0.53) -0.00) 0.03 (0.02 (0.00 (0.01 (0.89) 0.07 (0.00 (0.03 (0.04 (0.02 (0.01 (0.00 (0.04) 0.03 (0.39) Percentage 90 0.11 (0.01 (0.10) Best strategy 0.02 (0.00) -0.01) -0.15 (0.04 (0.05) 0.01 (0.00 (0.00) Table 4: OLS estimates of the regression equation.00) -0.06) 0.00) 0.00) 0.04 (0.14 (0.61) 0.01) -0.00 (0.46 (0.01 (0.01 (0.01 (0.00 (0.03 (0.00) 0.

PhD Statistical arbitrage and pairs trading . Thomaidis.Trading costs Nikos S.

Trading costs Pairs trading is a cost-sensitive strategy Nikos S. PhD Statistical arbitrage and pairs trading . Thomaidis.

Thomaidis.Trading costs Pairs trading is a cost-sensitive strategy It involves Nikos S. PhD Statistical arbitrage and pairs trading .

Trading costs Pairs trading is a cost-sensitive strategy It involves Frequent re-balancing of trading positions Nikos S. PhD Statistical arbitrage and pairs trading . Thomaidis.

PhD Statistical arbitrage and pairs trading .Trading costs Pairs trading is a cost-sensitive strategy It involves Frequent re-balancing of trading positions Multiple openings and closings of trades Nikos S. Thomaidis.

Thomaidis.Trading costs Pairs trading is a cost-sensitive strategy It involves Frequent re-balancing of trading positions Multiple openings and closings of trades Short-selling Nikos S. PhD Statistical arbitrage and pairs trading .

Thomaidis. PhD Statistical arbitrage and pairs trading . margin requirements.Trading costs Pairs trading is a cost-sensitive strategy It involves Frequent re-balancing of trading positions Multiple openings and closings of trades Short-selling Transaction costs. etc Nikos S.

Thomaidis. margin requirements. etc How the strategies are expected to perform in a more realistic market environment? Nikos S.Trading costs Pairs trading is a cost-sensitive strategy It involves Frequent re-balancing of trading positions Multiple openings and closings of trades Short-selling Transaction costs. PhD Statistical arbitrage and pairs trading .

Trading costs Pairs trading is a cost-sensitive strategy It involves Frequent re-balancing of trading positions Multiple openings and closings of trades Short-selling Transaction costs. Thomaidis. etc How the strategies are expected to perform in a more realistic market environment? Can generated proﬁts oﬀset trading costs? Nikos S. PhD Statistical arbitrage and pairs trading . margin requirements.

7 35 71.05) Notes: (1) Averages over all parametrisations.32 (2. PhD Statistical arbitrage and pairs trading .50 (30.24) 27. Thomaidis.15 (27.59) 195. (2) Standard deviation in parentheses.43 4.51 (1.88 3.94) 24.76 4.45) 0. Nikos S.17 (0.19 1.66) 30.59 (28.Descriptive statistics (1/2) Top-10% (IR) portfolio of strategies Sample period Total days in sample: Total trading days in sample: Total number of traded stocks: Group formation Total number of formed groups: Average size of groups: Group trading Total number of group openings during study: Number of groups that never open: Average number of active groups per trading day: Fraction of trading time groups are open: Average number of times a group is opened over the trading period: Average duration of positions (days): Average duration of long positions (days): Average duration of short positions (days): 4065 3865.

21 26. PhD Statistical arbitrage and pairs trading .34 Nikos S.13 13.Descriptive statistics (2/2) Top-10% (IR) portfolio of strategies Divergence risk Percentage of groups that never open: Percentage of groups opened once but never converging in the trading period: Percentage of groups that have multiple round-trip trades and a ﬁnal divergent trade: Percentage of groups with no ﬁnal divergent trade: Note: Averages over all 360 parametrisations. 3.31 57. Thomaidis.

31 2.24 2.55 1.93 4.28 2.32 Best 5.31 2. PhD Statistical arbitrage and pairs trading .93 4.27 Transaction cost Strategies Mean(%) Stdev(%) DStdev(%) IR DIR 50 bps Best at Zero Cost 4.93 4.33 2.55 1.14 1.25 2.36 Table 5: Top-10% (IR) portfolio.55 1.37 2.92 22.35 2.34 4.55 1.54 0.37 2. Nikos S. Thomaidis.78 4.54 1.32 10 bps Best at Zero Cost 5.The impact of transaction costs (1/2) Transaction cost4 Strategies Mean(%) Stdev(%) DStdev(%) IR DIR 0 bps Best at Zero Cost 5.30 2.10 5. 4 Fixed cost per unit of trading volume.54 1.12 Best 5.38 4.34 2.27 0.00 16.93 Buy & hold Best 5.

Thomaidis. Nikos S. PhD Statistical arbitrage and pairs trading .The impact of transaction costs (2/2) 160 140 120 cumulative return (%) 100 80 60 40 20 0 −20 Mar93 Dec95 Sep98 May01 Feb04 Nov06 Aug09 May12 0 bps 10 bps 50 bps Figure 8: Historical performance of the top-10% (IR) portfolio assuming diﬀerent levels of transaction costs.

Data snooping (1/2) Nikos S. PhD Statistical arbitrage and pairs trading . Thomaidis.

Thomaidis. PhD Statistical arbitrage and pairs trading .Data snooping (1/2) Statistical arbitrage strategies are highly parametrised Nikos S.

Data snooping (1/2) Statistical arbitrage strategies are highly parametrised If we experiment with enough parameter settings. some of them are likely to beat the benchmark under any performance measures. PhD Statistical arbitrage and pairs trading . Thomaidis. by chance alone Nikos S.

Data snooping (1/2) Statistical arbitrage strategies are highly parametrised If we experiment with enough parameter settings. some of them are likely to beat the benchmark under any performance measures.Oct 2008. Thomaidis. strategies that went short in DJIA stocks during the period Apr 2008 . by chance alone For example. PhD Statistical arbitrage and pairs trading . would possibly outperform the market portfolio in a longer sample Nikos S.

by chance alone For example.Oct 2008. PhD Statistical arbitrage and pairs trading .Data snooping (1/2) Statistical arbitrage strategies are highly parametrised If we experiment with enough parameter settings. Thomaidis. some of them are likely to beat the benchmark under any performance measures. strategies that went short in DJIA stocks during the period Apr 2008 . would possibly outperform the market portfolio in a longer sample Simply because of the special characteristics of this single period Nikos S.

Thomaidis. would possibly outperform the market portfolio in a longer sample Simply because of the special characteristics of this single period Data snooping(“dredging” or “ﬁshing”): The practice of hand-tailoring the trading strategy to the data under consideration [Sullivan et al. some of them are likely to beat the benchmark under any performance measures. by chance alone For example. 2000] Nikos S. 1999. strategies that went short in DJIA stocks during the period Apr 2008 ..Oct 2008. White.Data snooping (1/2) Statistical arbitrage strategies are highly parametrised If we experiment with enough parameter settings. PhD Statistical arbitrage and pairs trading .

Thomaidis.Data snooping (2/2) Is the seemingly outstanding performance Nikos S. PhD Statistical arbitrage and pairs trading .

Thomaidis.Data snooping (2/2) Is the seemingly outstanding performance → due to genuine superiority? Nikos S. PhD Statistical arbitrage and pairs trading .

Thomaidis.Data snooping (2/2) Is the seemingly outstanding performance → due to genuine superiority? or. PhD Statistical arbitrage and pairs trading . Nikos S...

→ due to luck? Nikos S.Data snooping (2/2) Is the seemingly outstanding performance → due to genuine superiority? or. PhD Statistical arbitrage and pairs trading .. Thomaidis..

http://equity.blogspot. PhD Statistical arbitrage and pairs trading . provided of course that we are allowed to test the rule on the same table of numbers which we used to discover the rule. 2000] “If you have 20.html Nikos S. we are sure that we can ﬁnd a mechanical trading rule which ‘works’ on a table of random numbers. but are in fact useless. 1970] “Even when no exploitable [trading] model exists.” [White. one of the monkeys will write the Iliad in ancient Greek. If you put enough monkeys on typewriters.” [Jensen and Bennington.000 traders in the market. 1997]5 5 Random Walk: Taleb on Mistakes that Market Traders can make.com/2008/11/taleb-on-mistakes-that-market-traders. But would you bet any money that he’s going to write the Odyssey next?” [Taleb. looking long enough and hard enough at a given set of data will often reveal one or more [trading strategies] that look good.Data snooping quotations “Given enough computer time. sure enough you’ll have someone who’s been up every day for the past few years and will show you a beautiful P&L. Thomaidis.

Thomaidis. PhD Statistical arbitrage and pairs trading .How to eliminate data snooping biases? Nikos S.

How to eliminate data snooping biases? Using an estimation and validation (test) data set Helps observing model performance beyond the training sample Sensitive with respect to the particular choice of sample periods (training and testing) Sensitive to market conditions Nikos S. Thomaidis. PhD Statistical arbitrage and pairs trading .

How to eliminate data snooping biases? Using an estimation and validation (test) data set Helps observing model performance beyond the training sample Sensitive with respect to the particular choice of sample periods (training and testing) Sensitive to market conditions Using multiple estimation/validation periods Reported performance is less prone to data-snooping biases Problems arise if these periods are consecutive The choice of periods can introduce further bias Nikos S. PhD Statistical arbitrage and pairs trading . Thomaidis.

Thomaidis. PhD Statistical arbitrage and pairs trading .How to eliminate data snooping biases? Using an estimation and validation (test) data set Helps observing model performance beyond the training sample Sensitive with respect to the particular choice of sample periods (training and testing) Sensitive to market conditions Using multiple estimation/validation periods Reported performance is less prone to data-snooping biases Problems arise if these periods are consecutive The choice of periods can introduce further bias Statistical techniques Little sensitivity to market conditions Helps exploring new market scenarios (beyond those present in the dataset) Nikos S.

PhD Statistical arbitrage and pairs trading . Thomaidis.How would you choose your sample periods? Buy & hold strategy 350 300 Cumulative return (%) 250 200 1998 2000 1999 2002 2003 2008 1997 2010 1996 1995 1994 2001 2004 2005 2006 2007 150 100 50 0 2009 −50 Mar93 Dec95 Sep98 May01 Feb04 Nov06 Aug09 May12 Nikos S.

PhD Statistical arbitrage and pairs trading . Thomaidis.Trading performance comparisons (1/2) Splitting the data set into estimation and validation periods Sample 1 Estimation period Validation period Number of observations (validation set) 1994.99 Sample 2 1997-99 2000-02 Sample 3 2000-02 2003-05 Sample 4 2003-06 2006-10 756 days 756 days 756 days 1041 days Nikos S.96 1997.

27 cumulative return (%) Top−10% (IR) Buy & hold IR=1.78 IR=0.05 0 −50 −5 Jul02 Jan03 Aug03 Feb04 Sep04 Mar05 Oct05 −50 May06 −10 Oct05 May06 Nov06 Jun07 Dec07 Jul08 Jan09 Aug09 −100 Mar10 Nikos S.52 Top−10% (IR) Buy & hold cumulative return (%) cumulative return (%) cumulative return (%) 10 0 0 0 IR=0.17 Buy & hold Jun96 Jan97 Jul97 Feb98 Sep98 Mar99 Oct99 Apr00 Nov00 May01 Validation set 4 Dec01 Jul02 Validation set 3 5 50 20 IR= −0. Thomaidis.21 30 20 10 0 −10 −20 −30 Jan03 cumulative return (%) cumulative return (%) 5 50 0 IR=1.55 50 Top−10% (IR) Buy & hold IR= 0.28 Top−10% (IR) IR=−0.Trading performance comparisons (2/2) Validation period 1 10 150 25 20 cumulative return (%) cumulative return (%) 100 15 10 5 0 0 Apr00 −5 Oct99 Validation set 2 IR=0. PhD Statistical arbitrage and pairs trading .

Statistical techniques

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

Statistical techniques

Random portfolios [Burns, 2006] How skillful is our strategy in terms of picking the right stocks

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

Statistical techniques

Random portfolios [Burns, 2006] How skillful is our strategy in terms of picking the right stocks at the right combination?

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

which opens and closes trading positions at random points? Nikos S. Thomaidis. 2006] How skillful is our strategy in terms of picking the right stocks at the right combination? “Monkey” trading Is our trading system superior to a “monkey”.Statistical techniques Random portfolios [Burns. PhD Statistical arbitrage and pairs trading .

PhD Statistical arbitrage and pairs trading .Statistical techniques Random portfolios [Burns. which opens and closes trading positions at random points? Other more sophisticated approaches: Reality Check [White. 2000] Test of Superior Predictive Performance [Hansen. 2005] False discovery rate [Bajgrowiczy and Scailletz. Thomaidis. 2009] Nikos S. 2006] How skillful is our strategy in terms of picking the right stocks at the right combination? “Monkey” trading Is our trading system superior to a “monkey”.

8 0.1 0 −0.2 0 0.6 0.1 −0. Thomaidis.4 0.Skillful vs lucky stock picking 1 Probability of superior group formation skills 0. PhD Statistical arbitrage and pairs trading .3 90th percentile 0.2 Median 10th percentile Dec95 Sep98 May01 Feb04 Nov06 Aug09 Top−10% (IR) strategy months of consecutive out performarnce months of consecutive under performarnce Dec95 Sep98 May01 Feb04 Nov06 Aug09 Nikos S.2 Monthly return 0.

10% Percentage of unskilled months: 36.Group-selection skills: interesting statistics Based on the probability of “superiority” Percentage of skilled months: 63. PhD Statistical arbitrage and pairs trading . Thomaidis.51 Average number of consecutive unskilled-picking months: 1.90% Average number of consecutive skillful-picking months: 2.47 Nikos S.

Do stock-picking beneﬁts accumulate over time? 300 Top−10% (IR) strategy 250 Probability of outperformance: 98. Thomaidis. PhD Statistical arbitrage and pairs trading .20% 200 Cumulative return (%) 150 100 50 0 −50 −100 Mar93 Dec95 Sep98 May01 Feb04 Nov06 Aug09 May12 Nikos S.

Nikos S.Is my trading system as smart as a monkey? 6 6 This particular monkey-trader was recruited from http://www.com/images/monkey_thinking-236. PhD Statistical arbitrage and pairs trading .free-extras. Thomaidis.htm .

Thomaidis.1 Monthly return 0 −0.2 10th percentile Dec95 Sep98 May01 Feb04 Nov06 Aug09 Nikos S.2 0 0.6 0.2 months of consecutive out performarnce months of consecutive under performarnce Dec95 90th percentile Sep98 May01 Feb04 Nov06 Top−10% (IR) strategy Aug09 0.8 0. PhD Statistical arbitrage and pairs trading .4 0.1 Median −0.Skillful vs lucky trading 1 Probability of superior group formation skills 0.

49 Nikos S. PhD Statistical arbitrage and pairs trading .31% Percentage of unskilled months: 32.62% Average number of consecutive skilled months: 2. Thomaidis.Group-trading skills: interesting statistics Percentage of skilled months: 66.88 Average number of consecutive unskilled months: 1.

PhD Statistical arbitrage and pairs trading . Thomaidis.Beating the monkey in terms of cumulative return 300 Top−10% (IR) strategy 250 Probability of outperformance: 98.20% 200 Cumulative return (%) 150 100 50 0 −50 −100 Mar93 Dec95 Sep98 May01 Feb04 Nov06 Aug09 May12 Nikos S.

How to improve your pairs trading system Nikos S. Thomaidis. PhD Statistical arbitrage and pairs trading .

How to improve your pairs trading system Use ﬁrm fundamentals to select stocks with similar factor risk exposure Nikos S. Thomaidis. PhD Statistical arbitrage and pairs trading .

PhD Statistical arbitrage and pairs trading .How to improve your pairs trading system Use ﬁrm fundamentals to select stocks with similar factor risk exposure Trade at higher frequencies (microstructure information) Nikos S. Thomaidis.

Thomaidis. PhD Statistical arbitrage and pairs trading .How to improve your pairs trading system Use ﬁrm fundamentals to select stocks with similar factor risk exposure Trade at higher frequencies (microstructure information) Select stocks with similar response patterns to market disturbances Nikos S.

How to improve your pairs trading system Use ﬁrm fundamentals to select stocks with similar factor risk exposure Trade at higher frequencies (microstructure information) Select stocks with similar response patterns to market disturbances → Event-response analysis [Pole. Thomaidis. PhD Statistical arbitrage and pairs trading . 2007] Nikos S.

**How to improve your pairs trading system
**

Use ﬁrm fundamentals to select stocks with similar factor risk exposure Trade at higher frequencies (microstructure information) Select stocks with similar response patterns to market disturbances → Event-response analysis [Pole, 2007] Incorporate any type of prior expert knowledge

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

**How to improve your pairs trading system
**

Use ﬁrm fundamentals to select stocks with similar factor risk exposure Trade at higher frequencies (microstructure information) Select stocks with similar response patterns to market disturbances → Event-response analysis [Pole, 2007] Incorporate any type of prior expert knowledge Achieve the right balance between automation and human intervention

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

**How to improve your pairs trading system
**

Use ﬁrm fundamentals to select stocks with similar factor risk exposure Trade at higher frequencies (microstructure information) Select stocks with similar response patterns to market disturbances → Event-response analysis [Pole, 2007] Incorporate any type of prior expert knowledge Achieve the right balance between automation and human intervention Is it possible to select the best-performing rules ex ante?

Nikos S. Thomaidis, PhD

Statistical arbitrage and pairs trading

Thomaidis. 2007] Incorporate any type of prior expert knowledge Achieve the right balance between automation and human intervention Is it possible to select the best-performing rules ex ante? Historical (in-sample) performance Nikos S.How to improve your pairs trading system Use ﬁrm fundamentals to select stocks with similar factor risk exposure Trade at higher frequencies (microstructure information) Select stocks with similar response patterns to market disturbances → Event-response analysis [Pole. PhD Statistical arbitrage and pairs trading .

Thomaidis.How to improve your pairs trading system Use ﬁrm fundamentals to select stocks with similar factor risk exposure Trade at higher frequencies (microstructure information) Select stocks with similar response patterns to market disturbances → Event-response analysis [Pole. PhD Statistical arbitrage and pairs trading . 2007] Incorporate any type of prior expert knowledge Achieve the right balance between automation and human intervention Is it possible to select the best-performing rules ex ante? Historical (in-sample) performance Economic conditions (picking those rules that perform better with a particular state of the business and market cycle) Nikos S.

Nikos S. PhD Statistical arbitrage and pairs trading .35 1.95 0 local maxima Normalised price 20 40 60 80 Group formation period (days) 100 120 140 .2 1.3 1.Event-response analysis 1.05 1 0.25 1.15 local minima 1. Thomaidis.1 1.

PhD Statistical arbitrage and pairs trading .Epilogue Nikos S. Thomaidis.

Thomaidis.Epilogue Pairs trading is a statistical arbitrate trading strategy Nikos S. PhD Statistical arbitrage and pairs trading .

Thomaidis.Epilogue Pairs trading is a statistical arbitrate trading strategy Performs better under limiting conditions Nikos S. PhD Statistical arbitrage and pairs trading .

Thomaidis.Epilogue Pairs trading is a statistical arbitrate trading strategy Performs better under limiting conditions inﬁnitely-dimensional asset universe Nikos S. PhD Statistical arbitrage and pairs trading .

Epilogue Pairs trading is a statistical arbitrate trading strategy Performs better under limiting conditions inﬁnitely-dimensional asset universe inﬁnite amount of trading time. PhD Statistical arbitrage and pairs trading . etc Nikos S. Thomaidis.

Thomaidis. asset selection. etc Computational challenges (processing huge amounts of information. model estimation) Nikos S. ﬁne-tuning.Epilogue Pairs trading is a statistical arbitrate trading strategy Performs better under limiting conditions inﬁnitely-dimensional asset universe inﬁnite amount of trading time. PhD Statistical arbitrage and pairs trading .

Epilogue Pairs trading is a statistical arbitrate trading strategy Performs better under limiting conditions inﬁnitely-dimensional asset universe inﬁnite amount of trading time. etc Computational challenges (processing huge amounts of information. ﬁne-tuning. trading costs. Thomaidis. asset selection. model estimation) Implementation challenges (high portfolio turnover. PhD Statistical arbitrage and pairs trading . execution risk) Nikos S.

PhD Statistical arbitrage and pairs trading . trading costs. Thomaidis. ﬁne-tuning. etc Computational challenges (processing huge amounts of information. model estimation) Implementation challenges (high portfolio turnover. asset selection.Epilogue Pairs trading is a statistical arbitrate trading strategy Performs better under limiting conditions inﬁnitely-dimensional asset universe inﬁnite amount of trading time. execution risk) If beneﬁts exceed costs your system is a hit! Nikos S.

Burgess... Technical trading revisited: False discoveries. S.. S.. Computational Finance 1999. M. LeBaron. PhD Statistical arbitrage and pairs trading . Bajgrowiczy. P. Vadim. Y. and Seasholes. A. (2009).. and Scailletz. Thomaidis. W. persistence tests. N. The MIT Press. editors. pages 297–312. A. (2005). Lo. and Weigend. working paper. P. B.. Understanding the proﬁtability of pairs trading. and transaction costs. working paper. In Abu-Mostafa. Nikos S. Statistical arbitrage models of the FTSE 100.References I Andrade. (2000). O.

R. (2005). C. F. 55:251–276. and Rouwenhorst. estimation. and testing. A test for superior predictive ability. P. E. J. and Granger. Co-integration and error correction: Representation. 19(3):797–827. Econometrica. 23(5):365–380. Random portfolios for evaluating trading strategies. Goetzmann. W. (1987). (2006). Thomaidis. Nikos S. The Review of Financial Studies. Journal of Business & Economic Statistics. Hansen. P. working paper. Pairs trading: performance of a relative-value arbitrage rule. Gatev. Engle.References II Burns.. K. W. PhD Statistical arbitrage and pairs trading . (2006)..

and Bennington. Nikos S. 25:469 – 482. (1994). M. A drunk and her dog: An illustration of cointegration and error correction. The American Statistician. Inc. PhD Statistical arbitrage and pairs trading . Statistical arbitrage: algorithmic trading insights and techniques. (1970). Murray. John Wiley and Sons. Random walks and technical theories: some additional evidence. Thomaidis. M. (2007). Pole. The Journal of Finance. G. 48(1):37–39.References III Jensen. A.

G. H. Lecture Notes in Artiﬁcial Intelligence. Nikos S. Thomaidis. (2004).. N. N. Data-snooping. 3955:596–599. and Dounias. G. and Kondakis. 54:1647–1691. Inc. N. John Wiley and Sons.GARCH model... R. An intelligent statistical arbitrage trading system. A. The Journal of Finance. technical trading model performance and the bootstrap. (1999). Working paper available from SSRN.. Thomaidis. Timmermann. (2012). Vidyamurthy. PhD Statistical arbitrage and pairs trading . Pairs trading: quantitative methods and analysis. Kondakis. (2006). N. S.References IV Sullivan. S. Detecting statistical arbitrage opportunities using a combined neural network . Thomaidis. and White.

Trading pairs: capturing proﬁts and hedging risk with statistical arbitrage strategies.References V Whistler. 68(5):1097–1126. Nikos S. PhD Statistical arbitrage and pairs trading . (2000). H. M. Econometrica. White. John Wiley and Sons. Thomaidis. (2004). Inc. A reality check for data snooping.

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