Comparison Analysis of Arima and Z-test for Forecasting the Maximum Return Based on the Pair Trading Strategy

Abstract

The stock market trends are of great challenge. Even some of the mutual market's strategies, such as traditional pair trading strategy may still be risky and are likely to suffer an unbearable loss due to an unreasonable stop mechanism. In this paper, a novel approach of pair trading strategy – using the logarithmic return to generate pairs and those deviations to construct trading signals. In addition, two methods that ARIMA and Z-TEST used to construct trading signals are compared according to their corresponding cumulative returns. In part one, the ARIMA model has been used to identify whether there is a constant predictive power and how trading signals should be generated to obtain the highest returns. Therefore, a stationary test has been done, and an optimal threshold has been selected. In part two, the Z-test has been used to distribute the preceding data, and the best threshold to construct trading signals has been found in the same mechanism with that process of ARIMA. As a result, the Z-test method shows a better return than that of the ARIMA model, which could be caused by a more stable forecasting accuracy from the distribution. To conclude, this novel approach is efficacious to lower the risks from unanticipated extreme cases and unwise designs on stopping signals. Furthermore, the Z-test method for signals construction is more stable and profitable than the ARIMA. The research greatly maximizes profits in stock markets by selecting the best model and an optimal threshold that models should be applied.