Pairs Trading: Quantitative Methods and Analysis

CHAPTER 6

Pairs Selection in Equity Markets

INTRODUCTION

In Chapter 5, we explained that strategy design was essentially a three-step process. The three steps are identification of stock pairs, cointegration testing, and trading rule formulation. In this chapter, we focus on the first of the three steps, the process of identifying potential stock pairs. In this step we essentially short-list the pairs for cointegration testing and further analysis. Why do we need to do that? We could just as well work with a candidate list of all possible pairs, run cointegration tests on all of them, and eliminate pairs that fail the tests. This certainly seems reasonable, except for the fact that in a universe of 5,000 stocks, we have a total of about 12 million pairs. Running tests on 12 million pairs is definitely not a viable option. Therefore, the natural inclination is to try to reduce the number.

The most expedient way (not necessarily the best) to accomplish that is by using heuristics, or rules of thumb. In the heuristics approach, the list of pairs is explicitly partitioned into two sets: potentially cointegrated and not potentially cointegrated. This partitioning is accomplished by applying a set of rules. The rules are designed to exclude pairs with a slim chance of being cointegrated. This limits the number of pairs in the candidate list and reduces the number of cointegration ...