Pairs trading is a market-neutral strategy that involves simultaneously buying and selling two correlated assets to exploit their price discrepancies. The strategy aims to profit from the relative movements between the two assets, regardless of the overall market direction.
Pairs trading requires careful selection of pairs and constant monitoring to manage risks effectively. The usual pairs selection methods are based on distance, correlation, or cointegration. Reference [1] proposed a novel pairs selection method based on returns.
Return-based methods offer more robustness in situations where data are non-stationary or cointegration assumptions are not fulfilled. Additionally, return-based selection can be more adaptable to different market conditions since it doesn’t require stringent assumptions about the statistical properties of the data. Additionally, the authors choose pairs in the same sectors and utilize fundamental data, thus further minimizing risks. They pointed out,
The proposed SBPTS with a return-based pair selection technique demonstrates promising potential in exploiting price relationships within the same sector to achieve favorable trading outcomes. The SBPTS strategy offers several advantages. It leverages sector-specific information to enhance the accuracy of pair selection, increasing the potential for profitable trades. By concentrating on specific sectors, SBPTS aligns with the concept that stocks within the same sector tend to exhibit similar market behaviors, which can lead to more effective trading opportunities. SBPTS, by capitalizing on sector-specific correlations and price relationships, has shown the ability to generate substantial returns, making it a promising approach for pairs trading in different market environments. After conducting backtesting on the proposed SBPTS approach, the results indicate this strategy’s superior effectiveness and robustness.
In summary, a new pairs selection method based on the returns of stocks in the same sector is proposed; it offers good risk-adjusted returns.
We believe that the pairs selection method based on returns is innovative. Furthermore, we find it very interesting that the authors also developed a scheme for normalizing stock prices.
Let us know what you think in the comments below or in the discussion forum.
References
[1] PG Kolapwar, UV Kulkarni, JM Waghmare, Sector-based pairs trading strategy with novel pair selection technique, IEEE Transactions on Artificial Intelligence, 2024
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