In the last post, we had reviewed some theory related to pairs trade. In this post, we will go through a textbook case of arbitrage to show how various test-statistics should look like. We also introduce the half-life of mean-reversion and the Hurst Exponent as performance indicators. We then look into a possible implementation for mean-reversion strategy before discussing the real-world issue in pairs trade.
Pairs trade is one of the simplest market-neutral statistical arbitrage strategies. The goal is to find a pair of securities which historically move up and down in highly correlated fashion but the price differential between them is temporarily at an extreme. We then long the relatively cheap security and simultaneously short the other. Hopefully, the price differential would promptly revert back to normal such that we can realise some profit. We would review some useful statistical concept (such as co-integration, stationary process) and discuss the types of securities that are likely to form good trading pairs. Continue reading “Pairs Trade – Theory”