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Original Title: Pairs Trading

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You are on page 1of 21

Emmanuel Fua

Christopher Melgaard

James (Yi-Wei) Li

Background

Developed in the 1980s by a group of Quants at Morgan

Stanley, who reportedly made over $50 million profit for the

firm in 1987

A contrarian strategy that tries to profit from the principles

of mean-reversion processes

In theory, one could expand the strategy to include a basket

of more than a pair of related stocks

Main Idea

Choose a pair of stocks that move together very closely,

based on a certain criteria (i.e. Coke & Pepsi)

Wait until the prices diverge beyond a certain threshold, then

short the winner and buy the loser

Reverse your positions when the two prices converge -->

Profit from the reversal in trend

Example of a Pairs Trade

Investor Decisions

Pair Selection Criteria

Correlation (Parametric & Non-Parametric Spearmans Rho)

Dickey-Fuller Test Statistic (Cointegration)

Volatility of the Market

Historical returns

Cost of each transaction

Normalization of Stock Data

METHOD:

Find pair that has maximal correlation

Normalize price series, plot spread over 1 year formation period

Generate optimal threshold non-parametrically: choose a threshold Ti=c*sd(spread),

calculate profit for each Ti, choose Ti generating max profit

Calculate profit by going $1 short on winner, $1 long on loser; close position

when prices converge, i.e. spread=0

Normalize price series in 6 month trading period using mean and sd from

formation period

Plot spread using optimal threshold found from formation period, calculate profit

Lower thresholds More transactions Higher transaction costs Lower Returns

Higher transaction costs Smaller Returns

Chevron & Exxon

Formation Period Corr=0.93

Trading Period Corr=0.96

Optimal Threshold=1.25*sds

# Transactions=10

Returns=15%

Win.

Electronic Arts & GAP

Formation Corr=0.12

Trading Corr=0.56

Optimal Threshold=1 sd

# Transactions=0 (Open a position,

but spread never returns to 0)

Return= -0.04

Lose.

Nike & McDonalds

Formation Corr=0.87

Trading Corr=0.02

#Transactions=1

Return= -0.05

Lose.

Correlation is imperfect criteria

for selecting pairs.

Interesting result involving market

volatility

Trading Period

Formation Period

Pair Dates Corr. Optimal #Trans Returns Corr.

Threshold*

Exxon, Period 1 0.93 1 6 0.11 0.85

Chevron

Period 2 0.85 1.75 6 0.05 0.69

Period 3 0.93 1.25 10 0.15 0.96

Nike, Period 1 0.87 1.5 2 -0.05 0.02

McDonalds

Period 2 0.10 1 6 -0.02 0.29

Period 3 0.87 2 4 0.04 0.87

Electronic Period 1 0.12 1 0 -0.04 0.56

Arts, GAP

Period 2 0.19 2 4 -0.03 -0.09

Period 3 0.31 1.75 4 0.06 0.10

Period 3 includes January 2008, a very volatile month for the stock market.

It seems that high market volatility allows the possibility for positive profits for

uncorrelated pairs which would not generate such profits in low volatility periods,

although this can surely work either way.

Cointegration

If there exists a relationship between two non-stationary I(1)

series,Y and X , such that the residuals of the regression

Yt 0 1 X t ut

are stationary, then the variables in question are said to be

cointegrated 55

X Y

50

stationary 15

10

0 10 20 30 40 50 60 70 80 90 100

Application to Pairs Trading

If we have two stocks, X & Y, that are cointegrated in their

price movements, then any divergence in the spread from 0

should be temporary and mean-reverting.

Spread

time

cointegration between prices and 2) estimating the constant

Testing For Cointegration

Many Methods most of them focus on testing whether the

residuals of Yt 0 1 X t ut are stationary processes

We use the Cointegrating Regression Dickey-Fuller Test,

which essentially operates the following regression:

ut = ut-1 + et

Ha: < 0 => cointegration*

To obtain the cointegration factor estimates, we must

regress the de-trended Yt on the de-trended Xt

* We must use critical values different from Gaussian ones due to non-symmetric

properties of the Dickey-Fuller distribution

Results of Test

NO PAIR OF PRICES ARE COINTEGRATED!

No surprise there

thresholds as we did with normalized data

same time period

Normalization Vs Cointegration

Figure 5: Normalized strategy VS Cointegrated strategy

LUV(Southwest Airlines) &

PLL (Pall Corporation) Normalization Cointegration

over Formation Period 0.24 -0.52*

Cointegration Factor

N/A 0.43

Optimal SD Threshold over

Formation Period 1.25 SDs 1.75 SDs

Optimal Returns

over Formation Period ~0% ~2%

Number of Transactions

over Trading Period 4 4

Returns

over Trading Period ~5% ~13%

*CRDF statistic insignificant against the H0: The Time Series is not cointegrated (5% critical value = -3.39)

**Fixed transaction costs implicit in both models

Trading Period Comparison

Figure 6: Normalized LUV & PLL spreadVS Cointegrated LUV & PLL spread

Auto-Regressive Time Series

Cointegration is an ideal construct for pairs trading

But Dickey-Fuller Hypothesis Test is inconclusive

Instead we can fit a time series to the spread data

AR(1): Yt = Yt-1 + t

|| < 1, so that will be stationary.

Choosing thresholds with AR(1)

For the interest of time, we are only going to focus our

most cointegrated pair: LUV and PLL.

We will fit an AR(1) to the data by estimating and

the standard deviation of each iid white noise t.

Then we will run one thousand simulations of this

AR(1) model and estimate each of their optimal

benchmarks

The average of the optimal benchmarks from each

simulation will serve as our estimate for the optimal

benchmark in the formation period.

Results of AR(1) Thresholds

AR(1)

Coefficient 0.8605

estimate (-hat)

Optimal

Threshold 1.046

estimate

SD of Optimal

Threshold 0.2597

Number of

Transactions 12

Returns over

Trading Period 17.7%

Alternative Strategies

Conditional correlation or some other measure of

relatedness, such as Copulas

volatility, industry growth, etc.)

Bibliography

Gatev, Evan, William N. Goetzmann, and K. Geert Rouwenhorst, Pairs Trading:

Performance of a Relative-Value Arbitrage Rule, Review of Financial Studies (2006): 797-

827.

Jersey: John Wiley & Sons, Inc., 2004).

Thomson South-Western, 2006).

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