step by step guide: pair trading and statistical arbitrage
TRANSCRIPT
Statistical Arbitrage: Pair TradingShaurya ChandraQuantinsti
Content Index
• Process of Quant- Trading Strategy
• Statistical Arbitrage
• Pair Trading Strategy
• Implementation Methodology
• Example of Prices of two Cement Stock
• Pair Ratio Behavior
• Why Pair Trading Work?
• Key Decision Points for Pair Trading & Risk Area
• Investor Decisions
• Stationary Process
Content Index
• What’s Co-integration?
• Correlation Vs. Co-integration
• Correlation Calculation
• Co-Integration
• Co-Integration- Mathematical Definition:
• Co-integration calculation
• Pair Ratio Movement for Above Example
• Z-score
• Process of Pair Selection
• Other key points to be kept in mind
Process of Quant- Trading Strategy
Hypothesis Formulation
Back-Testing & Hypothesis Verification
Parameter Optimization
Going Live with Strategy
Implementation Methodology
Select pair
of stocks that
move together
closely
1
Wait until
prices diverge
beyond a certain
threshold, then
short “winner”
and buy
“loser”
2
Reverse your
positions when
the two prices
converge --> Profit
from the reversal
in trend
3
0.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00
160.00
180.00
0
200
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1400
3-Jan-05 3-Jan-06 3-Jan-07 3-Jan-08 3-Jan-09 3-Jan-10
ACC Ambuja
Example of Prices of two Cement Stock
0.100
0.105
0.110
0.115
0.120
0.125
0.130
Price Ratio 30 Day MA
Pair Ratio Behavior
Key Decision Points for Pair Trading & Risk Area
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0.7
0.75
0.8
0.85
0.9
0.95
1
1.05
Ratio Mean
Upper Line Lower line
Pair Ratio Movement for Above Example
Period:23-Oct-08 to 06-Nov-2009
30-Day Moving Average
+/- 2.25 Deviation
Mean fairly Stable
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
Z-Score
Z-…
Z-score
Zscore = (Pair Ratio –mean)/ (Standard Deviation)
Process of Pair Selection• The Process:
• Create a list of pairs based on the same sector and similar market capitalization
• Decide on the time horizon of trade ( hours, days, week or months etc)
• Find pair correlation for the universe defined above, choose pair with correlation above 0.60 for the desired trading horizon
• Check whether pair is co-integrated
• Calculate Price Ratio, Moving Average of Price Ratio
• To Normalize, calculate, standard deviation for Price Ratio and subsequently, calculate Z-score
• Based on the Z-score, define the pair entry points. Generally, z-score above +2 and below -2 are considered to be good measure of probability of pair exhibiting mean reversion
• Execute pair on rupee-neutral basis.
• Define, Strict Stop-Loss and Profit mechanism before entering trade
• Its good practice to allocate fund to different pair portfolio rather than one signal trade
Thank You!
To Learn Automated Trading
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