Pairs Trading using Data-Driven Techniques: Simple Trading Strategies Part 3 by Auquan auquan

Hence, stocks are needed to be selected for performing the pairs trading. One of the more notable hedge funds that implemented a pairs trading strategy https://investmentsanalysis.info/ was Long Term Capital Management. The company was founded in 1994 by John Meriwether, the former head of bond trading at Salomon Brothers.

• We show that the “static and dynamic optimality” is a viable approach to the time-inconsistent control problem.
• That means if the result of the above equation is positive, we are in profit.
• After backtesting the strategy on historical data, we evaluated its performance using a range of metrics including cumulative returns, maximum drawdown and the Sharpe ratio.
• This will result in a loss since stock A is increasing at a rate lower than stock B and you are short on stock B.
• The aim of pairs trading is to bet that, if the prices of 2 assets diverge, they will converge eventually.

If the correlation is high, say 0.8, traders may choose that pair for pairs trading. This high number represents a strong relationship between the two stocks. We then loop through the historical data, starting from the second day (since we need the previous day’s portfolio values to calculate the current day’s values). For each day, we check the buy_signal and sell_signal arrays to see if we should buy, sell, or hold the stocks.

Understanding Pairs Trade

However, with the benefits of the stock and ETF markets come their limitations. Shorting is vital for statistical arbitrage strategies, so as the investor, we need to be aware of the market’s requirements to be able to perform them. Applying statistical arbitrage strategies to equity or ETFs, we need to take into account three main points. Second – the less popular the stock or the ETF, the harder it is to find a willing lender to make the short possible, and third – legal restrictions on shorting can exist in different countries.

Since some clusters have too many stocks in them to properly visualize, the number of stocks in each time series plot is restricted to 100 for convenience. The From a visual perspective, stocks within the same cluster do show a good correlation among them in terms of the behavior of the stock prices. In our next stage, we want to pre-select eligible stocks that enable us to sail through further steps. First, we removed stocks that were delisted, exchanged, or merged during our sample period since those stocks are no longer tradable. Next, we removed stocks that have negative prices which will be problematic for further analysis. Stocks that are constantly trading at-low-volume also have to be removed since improper trading executions can largely change their stock prices and altered history.

Discipline + consistency = money

Then we perform a cumulative sum to get the value of X on each day. The resampling method addresses the weakness of the walk-forward technique, by introducing the assumption that future paths can be simulated by resampling of past observations. The resampling methods can https://day-trading.info/ vary from deterministic (jackknife, cross-validation) to random (subsampling, bootstrap). The ability to produce different paths in return allows us to do things like bootstrapping the Sharpe ratio distribution, which was impossible with a single path simulation.

• Section 2 introduces the nonparametric tolerance interval and one-step-ahead volatility prediction.
• One major risk in pairs trading is that you could get squeeze if both sides of the trade go the other way.
• One main loop is used so that the script can run continuously (perhaps on a server) without needing to stop and restart it as the market opens or closes.
• In this code, we define the spread as the difference between the returns of Apple and Microsoft.
• For instance, say you are LONG on the spread, that is, you have bought stock A and sold stock B as per the definition of spread in the article.

Copper, however, is slightly more sensitive to the building infrastructure of emerging economies, such as China and India, while crude oil pricing tends to be more sensitive to US demand. The example below shows the relationship between AME and DOV, notice how the spread is stationary enough for entry and exit positions to be taken and profits to be made. In the example below, we simulate a pair of co-moving assets using an implementation from ArbitrageLab. The first plot shows the co-moving assets whilst the bottom one illustrates how a mean-reverting spread is created by going long the first asset and short 60% in the second.

Summary: does pairs trading work?

Requiring only a correlation of 0.80 can also decrease the likelihood of the expected outcome. It is the responsibility of the trader to manage the position according not only to the predetermined buy and sell rules, but also to the changing market environment. The trader must be cognizant of the unexpected news releases affecting either of the instruments in a trade and be prepared to adjust their thinking accordingly.

Hedging is done in this strategy as the trader sells the overvalued security and purchases the undervalued security, thereby, limiting the chances of loss. We can also calculate the Sharpe ratio, a measure of risk-adjusted performance, using the daily returns of the portfolio. The Sharpe ratio is defined as the ratio of the average excess return over the risk-free rate to the standard deviation of the excess return. After looping through the historical data, we can calculate the cumulative returns of the portfolio and the two stocks, AAPL and MSFT, over time.

I Needed Money, So I Started Options-Hacking

After calculating the Sharpe Ratio, let’s move on to calculating the maximum drawdown of the strategy. The maximum drawdown is a measure of the largest percentage https://forex-world.net/ drop in asset value from a previous peak value. It gives us an idea of the risk and potential losses that can be incurred by investing in the strategy.

Section 3 illustrates the algorithm for pair trading of multiple assets. Section 4 describes our data for ten baskets of AI stocks in the U.S. equity markets. Section 5 explains the proposed semi-parametric version of the tolerance interval approach to generate trading entry and exit signals and shows our multi-asset pair-trading profitability. Pairs trading is among the most popular trading strategies in many markets, ranging from equities and ETFs to currencies and futures markets.