Inter-market pairs trading strategy construction using stochastic approach

Abstract

Pairs trading, a strategy used for statistical arbitrage, is a popular market-neutral trading strategy that matches a long position with a short position in two correlated stocks. It works by finding two stocks that move together, and taking long or short positions when they diverge abnormally, expecting that their prices will converge in the future. There are three categories of approaches to pairs trading: the distance method, the co-integration method and the stochastic method. In this paper, we mainly study strategy construction based on stochastic approach. It shows that there exists statistical arbitrage opportunities between commodities markets, currency exchange market and stock market, indicating the deficiency of market efficiency between different sectors of financial market. The main work of this paper includes two parts: constructing a novel stochastic bid-ask spread approach in inter-market as well as evaluating the performances of classic pairs trading strategies, and developing a loss protection pairs trading strategy focusing on the control of positions in pairs trading. Stochastic approach incorporates mean reversion process into pairs trading framework, and this property is the most important statistical relationship required for success. If the value of a portfolio is known to uctuate around its equilibrium value over time, then any deviations from this equilibrium can be traded against. Especially in this thesis, pairs trading strategies are developed based on stochastic forecasting process in terms of bid-ask spread between a pair of assets. The mean reverting stochastic process, described as Ornstein-Uhlenbeck (OU) process, is used to analyze the properties of price time series of assets. Two OU processes based on two bid-ask spreads are developed. Least square regression method is adopted to estimate the parameters of two models. To evaluate the performances of the proposed strategies, several classic pairs trading strategies are discussed in this thesis. We also investigate the profitability of classic pairs trading strategies in high frequency trading, when both bid-ask spread and transaction costs are included. We apply the pairs trading strategy to three selected categories of equities in inter-market, to examine whether positive excess return can be generated in heterogeneous groups. We find that pairs trading is able to achieve statistically significant daily excess returns on average for almost all the approaches if no transaction costs or bid-ask spreads are included. But once the transaction costs or bid-ask spreads are included in the experiments, their performances become bad, except that the stochastic model with transaction cost embedded can still achieve good returns if only transaction cost is included. Based on this phenomenon, we develop a new stochastic approach based on bid-ask price spread for pairs trading by constructing the model with both factors. It is an extension of the stochastic model proposed by Bertram. In this model, we integrate two bid-ask OU processes, assuming that the two bid-ask spread time series are highly correlated and both follow the mean-reverting process, which is tested by co-integration method. Our empirical results show that the proposed strategy is profitable with a daily average excess return of 0.03%, taken as the mean of all returns of different frequencies, when including only the bid-ask spreads. The issue of effective bid-ask spread and transaction cost is also discussed. We find that the steady effective bid-ask spread and transaction costs can be estimated as 70 bp. and 80 bp., respectively, providing evidence for argument about effective bid-ask spread and transaction costs in GateV et al. (2006)[59]. We also present the performances of top 10 profitable pairs during the total trading periods in 1-minute frequency, and find that the pair lists of top 10 for all approaches are almost the same, and active pairs always exist between foreign currency and precious metal assets. Moreover, according to the empirical comparisons between the classic strategies and the proposed strategy, the tiny difference between parameters of entry rule, might lead a negative excess return to positive return. In addition, we develop another model to obtain a minimum return per trade to control positions in pairs trading, acting as a complementary part for the stochastic approach based on bid-ask prices. Combining the optimal entry and exit rules with the loss protection model, more returns can be generated by controlling the number of trade units at every run.

Date of Award	3 Oct 2014
Original language	English
Awarding Institution	City University of Hong Kong
Supervisor	Kin Keung LAI (Supervisor) & Karthik Balkrishnan NATARAJAN (Supervisor)