A pairs trading strategy based on mixed copulas

Abstract

We propose an alternative pairs trading strategy based on computing a mispricing index in a novel way via a mixed copula model, or more specifically via an optimal linear combination of copulas. We evaluate the statistical and economic performances of our proposed approach by analyzing S&P 500 daily stock returns between 1990 and 2015. Empirical results are obtained not only from the full sample analysis but also from subperiods analyses. These subperiods are chosen in two different ways: i) fixed time length; and ii) bull/bear market dependent. Our empirical results suggest that overall the mixed copula strategy has a superior performance than the distance approach in terms of average returns and Sharpe ratio, considering or not the cost transaction. The superiority is more obvious during crisis periods.