Statistical Arbitrage with Pairs Trading

Posted: 26 May 2015 Last revised: 16 Oct 2015

See all articles by Ahmet Goncu

Ahmet Goncu

Xi'an Jiaotong University (XJTU)

Erdinc Akyildirim

Akdeniz University

Multiple version iconThere are 2 versions of this paper

Date Written: May 25, 2015

Abstract

We analyze statistical arbitrage with pairs trading assuming that the spread of two assets follows a mean-reverting Ornstein-Uhlenbeck process around a long-term equilibrium level. Within this framework, we prove the existence of statistical arbitrage and derive optimality conditions for trading the spread portfolio. In the existence of uncertainty in the long-term mean and the volatility of the spread, statistical arbitrage is no longer guaranteed. However, the asymptotic probability of loss can be bounded as a function of the standard error of the model parameters. The proposed framework provides a new filtering technique for identifying best pairs in the market. Backtesting results are given for the five pairs of stocks considered in Zeng and Lee (2014).

Keywords: Statistical arbitrage, Pairs trading, Optimal trading, Ornstein-Uhlenbeck process

Suggested Citation

Goncu, Ahmet and Akyildirim, Erdinc, Statistical Arbitrage with Pairs Trading (May 25, 2015). Available at SSRN: https://ssrn.com/abstract=2610064 or http://dx.doi.org/10.2139/ssrn.2610064

Ahmet Goncu

Xi'an Jiaotong University (XJTU) ( email )

26 Xianning W Rd.
Suzhou, Jiangsu 215123
China

Erdinc Akyildirim (Contact Author)

Akdeniz University ( email )

Antalya, Kampus
Turkey

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