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Nonparametric tolerance limits for pair trading

Author

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  • Chen, Cathy W.S.
  • Lin, Tsai-Yu

Abstract

Tolerance interval is an important statistical tool for determining the threshold of a certain reference. We propose to utilize nonparametric one-sided tolerance limits with three look-back window sizes for return spreads in order to find trading entry and exit signals. We illustrate how the proposed method help uncover arbitrage opportunities via the daily return spreads of 12 stock pairs in the U.S. markets and then report the performance of pair trading for two out-of-sample periods. The empirical results suggest that combining the minimum squared distance method and nonparametric one-sided tolerance limits generates positive excess returns, relative to the underlying stocks.

Suggested Citation

  • Chen, Cathy W.S. & Lin, Tsai-Yu, 2017. "Nonparametric tolerance limits for pair trading," Finance Research Letters, Elsevier, vol. 21(C), pages 1-9.
    • Handle: RePEc:eee:finlet:v:21:y:2017:i:c:p:1-9
    DOI: 10.1016/j.frl.2016.11.002
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    References listed on IDEAS

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    1. Evan Gatev & William N. Goetzmann & K. Geert Rouwenhorst, 2006. "Pairs Trading: Performance of a Relative-Value Arbitrage Rule," The Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 797-827.
    2. Robert Elliott & John Van Der Hoek & William Malcolm, 2005. "Pairs trading," Quantitative Finance, Taylor & Francis Journals, vol. 5(3), pages 271-276.
    3. Peter Laurence & Tai-Ho Wang, 2008. "Distribution-free upper bounds for spread options and market-implied antimonotonicity gap," The European Journal of Finance, Taylor & Francis Journals, vol. 14(8), pages 717-734.
    4. Young, Derek S., 2010. "tolerance: An R Package for Estimating Tolerance Intervals," Journal of Statistical Software, Foundation for Open Access Statistics, vol. 36(i05).
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Law, K.F. & Li, W.K. & Yu, Philip L.H., 2018. "A single-stage approach for cointegration-based pairs trading," Finance Research Letters, Elsevier, vol. 26(C), pages 177-184.
    2. Lin, Tsai-Yu & Chen, Cathy W.S. & Syu, Fong-Yi, 2021. "Multi-asset pair-trading strategy: A statistical learning approach," The North American Journal of Economics and Finance, Elsevier, vol. 55(C).

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    More about this item

    Keywords

    Pair trading; Nonparametric one-sided tolerance limits; Minimum squared distance method; Out-of-sample forecasting; Spreads;
    All these keywords.

    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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