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Evaluation of Dynamic Cointegration-Based Pairs Trading Strategy in the Cryptocurrency Market

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  • Masood Tadi
  • Irina Kortchmeski

Abstract

This research aims to demonstrate a dynamic cointegration-based pairs trading strategy, including an optimal look-back window framework in the cryptocurrency market, and evaluate its return and risk by applying three different scenarios. We employ the Engle-Granger methodology, the Kapetanios-Snell-Shin (KSS) test, and the Johansen test as cointegration tests in different scenarios. We calibrate the mean-reversion speed of the Ornstein-Uhlenbeck process to obtain the half-life used for the asset selection phase and look-back window estimation. By considering the main limitations in the market microstructure, our strategy exceeds the naive buy-and-hold approach in the Bitmex exchange. Another significant finding is that we implement a numerous collection of cryptocurrency coins to formulate the model's spread, which improves the risk-adjusted profitability of the pairs trading strategy. Besides, the strategy's maximum drawdown level is reasonably low, which makes it useful to be deployed. The results also indicate that a class of coins has better potential arbitrage opportunities than others. This research has some noticeable advantages, making it stand out from similar studies in the cryptocurrency market. First is the accuracy of data in which minute-binned data create the signals in the formation period. Besides, to backtest the strategy during the trading period, we simulate the trading signals using best bid/ask quotes and market trades. We exclusively take the order execution into account when the asset size is already available at its quoted price (with one or more period gaps after signal generation). This action makes the backtesting much more realistic.

Suggested Citation

  • Masood Tadi & Irina Kortchmeski, 2021. "Evaluation of Dynamic Cointegration-Based Pairs Trading Strategy in the Cryptocurrency Market," Papers 2109.10662, arXiv.org.
    • Handle: RePEc:arx:papers:2109.10662
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    References listed on IDEAS

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    1. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    2. Neil Gandal & Hanna Halaburda, 2016. "Can We Predict the Winner in a Market with Network Effects? Competition in Cryptocurrency Market," Games, MDPI, vol. 7(3), pages 1-21, July.
    3. Christopher Krauss, 2017. "Statistical Arbitrage Pairs Trading Strategies: Review And Outlook," Journal of Economic Surveys, Wiley Blackwell, vol. 31(2), pages 513-545, April.
    4. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-1580, November.
    5. Perlin, M., 2007. "Evaluation of pairs trading strategy at the Brazilian financial market," MPRA Paper 8308, University Library of Munich, Germany.
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    Cited by:

    1. Almeida, José & Gonçalves, Tiago Cruz, 2023. "A systematic literature review of investor behavior in the cryptocurrency markets," Journal of Behavioral and Experimental Finance, Elsevier, vol. 37(C).

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