Pairs Trading: Quantitative Methods and Analysis

CHAPTER 8

Trading Design

INTRODUCTION

In the discussions so far, we have established that a key requirement for pairs trading is the existence of an equilibrium relationship between the log price series of two stocks. We also discussed that the equilibrium relationship is characterized by two quantities: the cointegration coefficient and the equilibrium value. Once they are known, they can be used to construct the linear combination of the log prices of the two stocks, which is referred to as the spread. Pairs trading is a bet on the mean reversion property of the spread. When we make the determination that the spread has diverged sufficiently from the equilibrium value, we enter into an appropriate position in the two stocks, betting that the divergence will correct itself, and the spread would revert back to equilibrium. It is therefore important for us to explicitly define what would qualify as a sufficient divergence of the spread value from equilibrium for us to consider entering into a trade. The explicit specification of the divergence level enables us to boil down the actual trading of the spread to an unambiguous set of simple rules, which we will also refer to as trading signals. Obviously, the proper design of trading signals has a strong bearing on the profit loss picture and is therefore an important topic for discussion.

Let us look at what we would need in order to design the trading rules. Well, if the dynamics of the spread are known, then we can design our ...