Pair Trading Stocks As Well As The Life-Cycle Of Strategies

I convey discussed inwards diverse articles trading the spreads betwixt pairs of ETF’s, or betwixt a handbasket of stocks against an ETF using cointegration technique. There is, however, a glaring omission, equally I haven’t yet mentioned the classic statistical arbitrage strategy: pair-trading stocks.

There are pros as well as cons on applying cointegration to pair-trading stocks. On the pro side: because of the large release of stocks, nosotros tin savour a highly diversified portfolio that improves the validity of our results. Even if a release of spreads neglect to cointegrate going forward, nosotros tin count on a larger release of spreads that soundless do. (For e.g. my USO-XLE spread roughshod apart, piece GLD-GDX spread is soundless tightly cointegrated.) There are ii principal cons: 1) stocks are discipline to diverse specific risks which may homecoming our purely statistical model useless, specially inwards M&A situations. Therefore it is customary to withdraw such stocks from our portfolio when they are involved inwards special situations – however, past times the fourth dimension the intelligence is populace nosotros may convey incurred substantial loss already; also 2) because of the technique’s long history, it became known to many hedge funds as well as indeed students of finance, as well as so dyad trading stocks has non been real profitable, specially inwards the menstruation 2003-2005. Here I plotted the excess returns of the strategy equally applied to the States banking concern stocks from 20010102-20041231. (Excess returns agency credit involvement on margin residuum is non included.)

Interestingly, when a strategy becomes likewise pop as well as less profitable, many traders get-go to abandon it, or at to the lowest degree cut down their trading upper-case missive of the alphabet invested inwards the strategy. After a while, its popularity decreases, as well as the profitability recovers! This life-cycle of strategies reveals itself equally mean-reversion of strategies, on altitude of mean-reversion of stock prices. In our case, this strategy recovery starts inwards 2005, as well as is soundless inwards full-force. Here I plotted the excess returns of the strategy equally applied to the States banking concern stocks from 20050103 to 20070531:

The average annual excess homecoming inwards 2005-now is virtually 7.7% (on one-side of capital), as well as the Sharpe ratio is 0.8. Since I convey applied the technique on solely i manufacture group, diversification is express as well as so the Sharpe ratio is low. For the interested readers, they tin endeavour to apply this technique to to a greater extent than manufacture groups as well as possibly generate a higher Sharpe ratio. Even alongside only i manufacture group, this trading strategy may hold upwardly a practiced complement to a portfolio heavy on trend-following strategies as well as so require a reversal model to smoothen out the returns.

I convey started a model portfolio inwards my subscription expanse to demonstrate this strategy which volition hold upwardly updated daily unopen to 3pm ET. Other details of the strategy volition hold upwardly detailed inwards an accompanying article at that spot equally well.