The Profitability of Pairs Trading Strategies: Distance, Cointegration, and Copula Methods
Rad, Hossein, Low, Rand Kwong Yew and Faff, Robert W., The Profitability of Pairs Trading Strategies: Distance, Cointegration, and Copula Methods, Quantitative Finance, DOI: org/10.1080/14697688.2016.1164337
35 Pages Posted: 5 Jun 2015 Last revised: 19 May 2016
Date Written: June 3, 2015
We perform an extensive and robust study of the performance of three different pairs trading strategies - the distance, cointegration, and copula methods - on the entire US equity market from 1962 to 2014 with time-varying trading costs. For the cointegration and copula methods, we design a computationally efficient 2-step pairs trading strategy. In terms of economic outcomes, the distance, cointegration, and copula methods show a mean monthly excess return of 91, 85, and 43 bps (38, 33, and 5 bps) before transaction costs (after transaction costs), respectively. In terms of continued profitability, from 2009, the frequency of trading opportunities via the distance and cointegration methods is reduced considerably whereas this frequency remains stable for the copula method. Further, the copula method shows better performance for its unconverged trades compared to those of the other methods. While the liquidity factor is negatively correlated to all strategies' returns, we find no evidence of their correlation to market excess returns. All strategies show positive and significant alphas after accounting for various risk-factors. We also find that in addition to all strategies performing better during periods of significant volatility, the cointegration method is the superior strategy during turbulent market conditions.
Keywords: pairs trading, copula, cointegration, quantitative strategies, statistical arbitrage
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation