Pairs Trading, Technical Analysis, and Data Snooping: A Two-layer Manipulation-proof Performance Approach
70 Pages Posted: 8 Mar 2018 Last revised: 10 May 2019
Date Written: May 6, 2019
Traders typically lock in gains and gamble on losses, as prospect theory suggests. The disarmingly simple idea behind pairs trading can lead to doubling strategies with potentially delusive performance. In this paper, we develop a two-layer approach for evaluating the out-of-sample performance of technical analysis on frequently traded pairs using daily data from 1990 to 2016, while testing for presence of manipulative concave payoffs. The empirical evidence suggests that any short-term outperformance is mainly manipulation-free and rejects the existence of a uniformly monotonic downward trend over the years. For commodity spreads, the evidence of significant and skilled returns appears stronger.
Keywords: Pairs Trading, Technical Analysis, Data Snooping, Transaction Costs
JEL Classification: C12, C53, G11, G14, G15
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