Pre-selection in Cointegration-based Pairs Trading
31 Pages Posted: 30 Jun 2020 Last revised: 11 Mar 2021
Date Written: June 24, 2020
This paper compares the final profitability of a cointegration-based pairs trading strategy when pairs of stocks are pre-selected using seven different measures. Pre-selection matters, since the excess returns remarkably vary, in terms of both average and variability, depending on the metrics used. Differences in profitability by pre-selection metrics are retrieved even after considering commissions and cut rules, market impact, and a stricter definition of the Spread reversion to the equilibrium. Besides, the profitability of the pairs trading strategy is also found heterogeneous across the different pre-selection metrics considered in terms of exposure to the traditional risk-factors.
Keywords: pairs trading, pre-selection, cointegration, profitability
JEL Classification: G10, G12, C44, C55
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