Optimal Pairs Trading Strategy under Geometric Brownian Motion and its Application to the US stocks

Abstract

This study is a study on pair trading, a representative market-neutral investment strategy. A general pair trading strategy uses econometric techniques to select a pair of stocks and calculates the trading price level depending on a single variable called the variance of stock returns without any theoretical background. This study applies the optimal pair trading strategy proposed by Liu et al. (2020) to the top US market cap stocks and examines its performance. This strategy proposes a mathematical background for optimally calculating the trading price level. Since the statistical method for pair selection can be omitted, a pair can be formed only with good stocks with guaranteed liquidity. In addition, strategic risk management is possible because the stop loss set according to the market situation is performed. As the top 10 market cap stocks traded on the US exchange, daily closing price data for 10 years from 2011 to 2020 were applied to optimal pair trading. It was confirmed that the rate of return may differ depending on the adjustment of various parameters including the level of stop loss. In this study, an applicated strategy that properly managed pairs trading and stocks together earned the minimum annual average return 17.88% and the Sharpe ratio reached 1.81. These numbers can be better with the adjustment of the parameters.