Profitable Pair Trading: A Comparison Using the S&P 100 Constituent Stocks and the 100 Most Liquid ETFs

19 Pages Posted: 2 Jun 2013

See all articles by Jozef Rudy

Jozef Rudy

Harvest Alpha Capital

Christian Dunis

John Moores University - Business School

Jason Laws

University of Liverpool - Accounting and Finance Division

Date Written: November 10, 2010

Abstract

The motivation for this paper is to find out whether exchange traded funds (ETFs) are more suitable financial instruments for a pair trading strategy than stocks. The main advantage of pair trading ETFs is that ETFs cannot go bankrupt, which is not the case for shares. Thus, one of the greatest risks known for pair trading is eliminated.

Indeed, we find that an adaptive long-short strategy is more consistently profitable when it is applied to pairs consisting of ETFs rather than of shares, with an average out-of-sample information ratio of around 1 and 0, respectively.

By extending the in-sample period and decreasing the out-of sample period from 75%-25% to 83%-17% of the sample we were able to increase the average out-of-sample information ratio from 1 to 1.7 for ETFs and from 0 to 0.2 for shares. Yet, further improvement was achieved by preselecting pairs of ETFs and shares with the highest in-sample information ratios in the in-sample period. The average out-of-sample information ratios obtained for fifty such pairs selected from ETFs and shares were 2.93 and 0.46, respectively.

Keywords: Statistical arbitrage, ETFs, pairs trading, time adaptive models

JEL Classification: C00, C10, C50, G00, G11

Suggested Citation

Rudy, Jozef and Dunis, Christian and Laws, Jason, Profitable Pair Trading: A Comparison Using the S&P 100 Constituent Stocks and the 100 Most Liquid ETFs (November 10, 2010). Available at SSRN: https://ssrn.com/abstract=2272791 or http://dx.doi.org/10.2139/ssrn.2272791

Jozef Rudy (Contact Author)

Harvest Alpha Capital ( email )

Bratislava
Slovakia

Christian Dunis

John Moores University - Business School ( email )

John Foster Building
98 Mount Pleasant
Liverpool, L3 5UZ
United Kingdom

Jason Laws

University of Liverpool - Accounting and Finance Division ( email )

United Kingdom

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