Pairs trading strategies in a cointegration framework: back-tested on CFD and optimized by profit factor. Issue 22 (9th May 2019)

• Record Type: Journal Article
• Authors: Huang, Zhe; Martin, Franck
• Is Part Of: Applied economics. Volume 51:Issue 22(2019)
• Page Start: 2436
• Page End: 2452
• Publication Date: 2019-05-09
• Subjects: Pairs trading -- cointegration -- GARCH Model -- Bollinger bands -- back-testing -- profit factor; G11 -- D84 -- C53; Economics -- Periodicals; 330
• DOI: 10.1080/00036846.2018.1545080
• Languages: English
• ISSNs: 0003-6846

Abstract

ABSTRACT: Statistical arbitrage is based on pairs trading of mean-reverting returns. We used cointegration approach and ECM-DCC-GARCH to construct 98 pairs of 152 stocks of 3 currencies. Stocks trading is done by Contract for Difference (CFD), a financial derivative product which facilitates short selling and provides a leverage up to 25 times. To measure the performance of a leveraged strategy, we introduced the profit factor which is the annualized return rate per unit risk. And the historical risk is measured by maximum drawdown. We compared three main strategies: percentage, standard deviation of cointegration long-term residuals and Bollinger Bands (dynamic standard deviation), with and without double confirmation of short-term standard deviation modelled by ECM-DCC-GARCH. Each of the three main strategies is optimized by two optimizers: absolute profit and profit factor. The optimization period goes from 2012–01-01 to 2014–12-31, and validation period is from 2015–01-01 to 2016–06-01. Our results showed that the USD Bollinger Bands strategy without double confirmation and optimized by profit factor, outperformed other strategies and provided the highest annualized return rate per unit risk; 32% of our sample pairs ended up in loss, and 94% of which are explained by a cointegration break during the testing period.