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Improving Pairs Trading

Last Updated on 10 February, 2024 by Rejaul Karim

Diving into the intricacies of the Pairs Trading strategy, Tiago Almeida’s research paper, “Improving Pairs Trading,” critically evaluates the model proposed by Gatev, Goetzmann, and Rouwenhorst (2006).

The study scrutinizes whether the profitability of pairs initiated after an above-average volume day in one of the assets exhibits distinct return characteristics. Additionally, it explores the impact of introducing a limit on the number of days a pair remains open to enhance strategy returns.

The findings indicate that pairs initiated after a single-sided shock are less profitable. Notably, the introduction of a limitation on the duration of pairs significantly boosts profitability, with potential gains of up to 30 basis points per month. This research contributes valuable insights to refining and optimizing the effectiveness of the Pairs Trading strategy.

Abstract Of Paper

This paper tests the Pairs Trading strategy as proposed by Gatev, Goetzmann and Rouwenhorts (2006). It investigates if the profitability of pairs opening after an above average volume day in one of the assets are distinct in returns characteristics and if the introduction of a limit on the days the pair is open can improve the strategy returns. Results suggest that indeed pairs opening after a single sided shock are less profitable and that a limitation on the numbers of days a pair is open can significantly improve the profitability by as much as 30 basis points per month.

Original paper – Download PDF

Here you can download the PDF and original paper of Improving Pairs Trading.

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Author

Tiago Almeida
Independent; Catholic University of Portugal (UCP)

Conclusion

In summary, our study delves into enhancing the effectiveness of the Pairs Trading strategy, particularly as proposed by Gatev, Goetzmann, and Rouwenhorst (2006). By scrutinizing pairs formed after above-average volume days in one of the assets, we discern distinct return characteristics that contribute to a nuanced understanding of strategy profitability.

Notably, pairs initiated after a single-sided shock exhibit lower profitability. Moreover, our investigation introduces a pragmatic enhancement—imposing a limit on the duration a pair remains open. The results underscore the substantial improvement this constraint brings, leading to a noteworthy enhancement of up to 30 basis points per month in strategy returns.

This nuanced refinement contributes to the evolving landscape of Pairs Trading, offering practitioners an actionable avenue to optimize returns.

Related Reading:

Pairs Trading Strategy and Idiosyncratic Risk. Evidence in Spain and Europe.

On the Determinants of Pairs Trading Profitability

FAQ

– What is the main focus of Tiago Almeida’s research paper, “Improving Pairs Trading,” and what specific aspects of the Pairs Trading strategy does it critically evaluate?

The main focus of the research paper is to critically evaluate the Pairs Trading strategy proposed by Gatev, Goetzmann, and Rouwenhorst (2006). The study specifically scrutinizes whether pairs initiated after an above-average volume day in one of the assets exhibit distinct return characteristics. Additionally, it investigates the impact of introducing a limitation on the number of days a pair remains open to enhance the strategy’s returns.

– What are the key findings of the study regarding the profitability of pairs initiated after a single-sided shock and the impact of introducing a limitation on the duration of pairs?

The study finds that pairs initiated after a single-sided shock are less profitable. Importantly, the introduction of a limitation on the number of days a pair remains open significantly improves profitability. The results suggest that this constraint can enhance strategy returns by as much as 30 basis points per month, providing valuable insights into refining and optimizing the effectiveness of the Pairs Trading strategy.

– How does the research contribute to the evolving landscape of Pairs Trading, and what actionable avenue does it offer to practitioners seeking to optimize returns?

The research contributes to the evolving landscape of Pairs Trading by offering nuanced insights into strategy refinement. By highlighting the distinct return characteristics of pairs initiated after specific market events and demonstrating the significant improvement achieved by imposing a limit on pair duration, the study provides practitioners with an actionable avenue to optimize returns. This refined approach enhances the effectiveness of the Pairs Trading strategy, making it more adaptable and profitable in real-world applications.

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