Pairs trading strategies in a cointegration framework: back-tested on CFD and optimized by profit factor

Zhe Huang and Franck Martin
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Zhe Huang: CREM - Centre de recherche en économie et management - UNICAEN - Université de Caen Normandie - NU - Normandie Université - UR - Université de Rennes - CNRS - Centre National de la Recherche Scientifique

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Abstract: Statistical arbitrage is based on pairs trading of mean-reverting returns. We used cointegration approach and ECM-DCC-GARCH to construct 98 pairs of 152 stocks of 3 currencies. Stocks trading is done by Contract for Difference (CFD), a financial derivative product which facilitates short selling and provides a leverage up to 25 times. To measure the performance of a leveraged strategy, we introduced the profit factor which is the annualized return rate per unit risk. And the historical risk is measured by maximum drawdown. We compared three main strategies: percentage, standard deviation of cointegration long-term residuals and Bollinger Bands (dynamic standard deviation), with and without double confirmation of short-term standard deviation modelled by ECM-DCC-GARCH. Each of the three main strategies is optimized by two optimizers: absolute profit and profit factor. The optimization period goes from 2012–01-01 to 2014–12-31, and validation period is from 2015–01-01 to 2016–06-01. Our results showed that the USD Bollinger Bands strategy without double confirmation and optimized by profit factor, outperformed other strategies and provided the highest annualized return rate per unit risk; 32% of our sample pairs ended up in loss, and 94% of which are explained by a cointegration break during the testing period.

Keywords: back-testing; profit factor; Pairs trading; cointegration; GARCH Model; Bollinger bands (search for similar items in EconPapers)
Date: 2019-05-09
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Published in Applied Economics, 2019, 51 (22), pp.2436-2452. ⟨10.1080/00036846.2018.1545080⟩

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:halshs-01970192

DOI: 10.1080/00036846.2018.1545080

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