The Case of Gold and Silver: A New Algorithm for Pairs Trading

Abstract

In this paper we propose a new algorithm for pairs trading. Pairs Trading is a very popular trading strategy also known as market neutral position. The basic idea is to create a long/short position with securities that move together. Securities having strong co-relation (We propose correlation greater then 0.90) can be traded by using the proposed method in this paper. The basic concept of stochastic is applied to find the entry and exit points of a trade. The algorithm is tested on gold and silver prices for market neutral position. From a researcher’s point of view as per Efficient Market Hypothesis theory, pairs trading strategy should not result in positive returns as the past behavior of a stock price reflects the information flow of past. And has no effect on the future prices. The main objective of this research is to propose a simple method of pairs trading useful to market practitioners and researchers. The proposed algorithm generated 100% accurate trades with return of 44.45% for the test period.

Keywords: pairs trading, market neutral strategy, commodity trading, securities trading, market inefficiency, stochastic, efficient market hypothesis, trading strategies, bullion trading

JEL Classification: C10, C32, C40, C60, G14