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A single-stage approach for cointegration-based pairs trading

K.F. Law, W.K. Li and Philip L.H. Yu

Finance Research Letters, 2018, vol. 26, issue C, 177-184

Abstract: Pairs trading can be regarded as conditional mean reversion strategies. The conditions are usually imposed in two stages: Identification of pairs’ relationship and the opening (and closing) mechanism sequentially as a ‘pass or fail’ test. Nevertheless, as cointegration relationship is often not a ‘yes or no’ question but a ‘strong or weak’ one, dichotomizing the relationship through screening may not be optimal. This research presents a new single-stage approach to pairs trading based on a single ‘power statistic’. Its superiority in attaining better risk-to-reward ratios is demonstrated empirically in a large scale backtest study.11By ‘backtest study’, we refer to its common use in the formulation of a trading strategy in finance: The performance of a strategy if it had been employed during a past period using historical data.

Keywords: Cointegration; Pairs trading; Power statistic; Risk control; Return maximization (search for similar items in EconPapers)
Date: 2018
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