Pairs Selection Archives - Hudson & Thames

Distance Approach in Pairs Trading: Part I

Front Page Research, Statistical Arbitrage

There are many types of approaches you can use in pairs trading, but the Distance Approach is one of the most widely used because of its simplicity. The basic concept is as follows: Using Euclidean squared distance on the normalized price time series, n closest pairs of assets are chosen as pairs.

Then, with selected pairs, if the difference between the price of elements in a pair diverged by more than a threshold(ex. 2 standard deviations), the positions are opened. We have a long position for a stock with a lower price and a short position for a higher price in the portfolio.

Copula for Pairs Trading: A Unified Overview of Common Strategies

Front Page Research, Statistical Arbitrage

Systematic approaches of pairs trading gained popularity from the mid-1980s. Gatev et al (2006) examined the profitability of a distance-based strategy on normalized prices. Cointegration is another common strategy incorporated approach as discussed in [Vidyamurthy (2004)]. Both methods are tied to the idea of a mean-reverting bet, and the trading signals are generated from the spread: when the spread widens, it is expected to narrow, and when it does happen the trader pockets the profit.

We have previously talked about several advantages from copula-based models in Copula for Pairs Trading: A Detailed, But Practical Introduction, and as a tool it analyzes the dependence structure among several random variables (For pairs trading it is just 2 random variables). We quickly summarize it here:

Employing Machine Learning for Pairs Selection

Front Page Research, Statistical Arbitrage

In this post, we will investigate and showcase a machine learning selection framework that will aid traders in finding mean-reverting opportunities. This framework is based on the book: “A Machine Learning based Pairs Trading Investment Strategy” by Sarmento and Horta.

A time series is known to exhibit mean reversion when, over a certain period, it reverts to a constant mean. A topic of increasing interest involves the investigation of long-run properties of stock prices, with particular attention being paid to investigate whether stock prices can be characterized as random walks or mean-reverting processes.

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