Pairs Trading: Quantitative Methods and Analysis

CHAPTER 7

Testing For Tradability

INTRODUCTION

In Chapter 6 we discussed the process of choosing potential stock pairs. In this chapter we will focus on whether the identified candidate pairs are actually tradable. Based on the discussions so far, we can state that a pair is tradable if the stocks making up the pair are cointegrated. We need to bear in mind, however, that in most cases we are dealing with systems that are not exactly cointegrated. As a matter of fact, in the course of examining the candidate pairs, we can almost always expect to have a residual factor exposure causing the phenomenon of mean drift, thereby resulting in the signal to be nonstationary. However, if the signal-to-noise ratio is good enough, then for all practical purposes we could treat the residual series as stationary for the time period of the trade. Based on the preceding observations we could refine the phrasing of our question as follows: How do we decide that a pair is tradable even though it deviates from ideal conditions of cointegration? To seek out an approach to answer that, we could draw on the insights gleaned from cointegration testing procedures. With that in mind, let us outline the process of verifying that two stocks are indeed cointegrated.

Most verification processes are based on the “If it walks like a duck and quacks like a duck, it must be a duck” philosophy. Needless to add, the approach to cointegration testing is also along the same lines. We identify the properties that ...