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A single-stage approach for cointegration-based pairs trading

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  • Law, K.F.
  • Li, W.K.
  • Yu, Philip L.H.

Abstract

Pairs trading can be regarded as conditional mean reversion strategies. The conditions are usually imposed in two stages: Identification of pairs’ relationship and the opening (and closing) mechanism sequentially as a ‘pass or fail’ test. Nevertheless, as cointegration relationship is often not a ‘yes or no’ question but a ‘strong or weak’ one, dichotomizing the relationship through screening may not be optimal. This research presents a new single-stage approach to pairs trading based on a single ‘power statistic’. Its superiority in attaining better risk-to-reward ratios is demonstrated empirically in a large scale backtest study.11By ‘backtest study’, we refer to its common use in the formulation of a trading strategy in finance: The performance of a strategy if it had been employed during a past period using historical data.

Suggested Citation

  • 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.
    • Handle: RePEc:eee:finlet:v:26:y:2018:i:c:p:177-184
    DOI: 10.1016/j.frl.2017.12.011
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    References listed on IDEAS

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    Cited by:

    1. Yen-Sheng Lee, 2022. "Representative Bias and Pairs Trade: Evidence From S&P 500 and Russell 2000 Indexes," SAGE Open, , vol. 12(3), pages 21582440221, August.
    2. Li, Yiyun & Law, Keith K.F., 2021. "Systematic risk in pairs trading and dynamic parameterization," Economics Letters, Elsevier, vol. 202(C).
    3. 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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