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The Profitability of Pairs Trading Strategies: Distance, Cointegration, and Copula Methods

Last Updated on 10 February, 2024 by Rejaul Karim

In the seminal work “The Profitability of Pairs Trading Strategies: Distance, Cointegration, and Copula Methods” authored by Hossein Rad, Rand Kwong Yew Low, and Robert W. Faff, a profound exploration into the performance of pairs trading strategies engenders a captivating discourse steeped in paradigm-shifting revelations.

Through an exhaustive examination spanning the years 1962 to 2014, the trio delves into the economic ramifications of the distance, cointegration, and copula methods, navigating the convoluted terrain of the US equity market.

Unveiling a mean monthly excess return of striking proportions for each method, the research unveils nuanced shifts in trading opportunities and the divergent performance of these strategies amidst seismic market turmoils, proffering an enigmatic revelation stippled with substantial correlations and positive alphas, thus etching a resplendent yet inscrutable mosaic of the pairs trading universe.

Abstract Of Paper

We perform an extensive and robust study of the performance of three different pairs trading strategies – the distance, cointegration, and copula methods – on the entire US equity market from 1962 to 2014 with time-varying trading costs. For the cointegration and copula methods, we design a computationally efficient 2-step pairs trading strategy. In terms of economic outcomes, the distance, cointegration, and copula methods show a mean monthly excess return of 91, 85, and 43 bps (38, 33, and 5 bps) before transaction costs (after transaction costs), respectively. In terms of continued profitability, from 2009, the frequency of trading opportunities via the distance and cointegration methods is reduced considerably whereas this frequency remains stable for the copula method. Further, the copula method shows better performance for its unconverged trades compared to those of the other methods. While the liquidity factor is negatively correlated to all strategies’ returns, we find no evidence of their correlation to market excess returns. All strategies show positive and significant alphas after accounting for various risk-factors. We also find that in addition to all strategies performing better during periods of significant volatility, the cointegration method is the superior strategy during turbulent market conditions.

Original paper – Download PDF

Here you can download the PDF and original paper of The Profitability of Pairs Trading Strategies: Distance, Cointegration, and Copula Methods.

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Author

Hossein Rad
University of Queensland Business School

Rand Kwong Yew Low
University of Queensland; Bond University

Robert W. Faff
University of Queensland; Bond University

Conclusion

In a resplendent crescendo, “The Profitability of Pairs Trading Strategies: Distance, Cointegration, and Copula Methods” emerges as a lighthouse, illuminating the swath of pairs trading strategies with profound luminescence.

The intricate findings proffer meticulous insights into the ecosystem of pairs trading, unfurling the economic effulgence of the distance, cointegration, and copula methods, intricately interwoven with temporal shifts and market vicissitudes.

This journey bequeaths a sagacious elucidation, delineating the ebbs and flows of trading opportunities, market resonance, and alpha generation, casting the cointegration method as the stalwart luminary amid turbulent market throes.

Collectively, this compendium delivers a resplendent yet enigmatic tableau, inviting further introspection into the enigmatic frontiers of quantitative strategies and statistical arbitrage.

Related Reading:

Selection of a Portfolio of Pairs Based on Cointegration: A Statistical Arbitrage Strategy

Asset Growth and the Cross-Section of Stock Returns

FAQ

1. What are the main pairs trading strategies explored in the research paper “The Profitability of Pairs Trading Strategies: Distance, Cointegration, and Copula Methods,” and what are their respective mean monthly excess returns?

The research paper explores three main pairs trading strategies: the distance method, cointegration method, and copula method. The mean monthly excess returns for these strategies are reported as follows:

  • Distance method: 91 bps before transaction costs, 38 bps after transaction costs.
  • Cointegration method: 85 bps before transaction costs, 33 bps after transaction costs.
  • Copula method: 43 bps before transaction costs, 5 bps after transaction costs.

2. How does the frequency of trading opportunities vary among the distance, cointegration, and copula methods, especially after 2009?

From 2009 onward, the frequency of trading opportunities via the distance and cointegration methods is considerably reduced. In contrast, the copula method exhibits a stable frequency of trading opportunities during this period. This difference highlights a shift in the dynamics of trading opportunities among the three methods in the post-2009 period.

3. What are the key findings regarding the performance of pairs trading strategies during periods of significant volatility, and which method is identified as the superior strategy during turbulent market conditions?

The research findings indicate that all strategies perform better during periods of significant volatility. However, the cointegration method is identified as the superior strategy specifically during turbulent market conditions. This suggests that the cointegration method exhibits robustness and outperformance when market conditions become more challenging and volatile.

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