Finding Close Economic Substitutes for Stock Pairs Trading
June 21, 2016 - Technical Trading
When does a cointegration test, which looks for a connection between two apparently wandering price paths, work for pairs trading? In their May 2016 paper entitled “Cointegration and Relative Value Arbitrage”, Binh Do and Robert Faff investigate the conditions under which cointegration successfully identifies stocks for pairs trading. Their basic pairs trading strategy is to each month:
- Identify cointegrated pairs based on daily total returns over the last 12 months.
- Over the next six months, buy (sell) the relatively undervalued (overvalued) stock when cointegrated pair spread exceeds its selection interval mean by two standard deviations.
- Close positions when the spread reverts to its historical mean or the trading period ends, whichever occurs first.
- Closed trades may be reopened as signaled, if there is more than a month left in the trading interval.
They then refine the strategy by constraining selected pairs to those that are close economic substitutes, corresponding to a low cointegration coefficient. Pairs passing (failing) this constraint move together in the long run without any price scaling (only with scaling of prices for one member of the pair). While they focus on pairs of individual stocks, they also consider trading of pairs of small groups (baskets) of stocks. Their benchmark is a conventional pairs trading strategy that identifies pairs with the smallest sums of squared differences in normalized daily prices over the past 12 months, and then trades as specified above over the next six months. Using daily data for a broad sample of U.S. common stocks during July 1962 through December 2013, they find that: Keep Reading