Abstract
Pairs trading is a typical example of a convergence trading strategy. Investors buy relatively under-priced assets simultaneously, and sell relatively over-priced assets to exploit temporary mispricing. This study examines optimal pairs trading strategies under symmetric and non-symmetric trading constraints. Under the assumption that the price spread of a pair of correlated securities follows a mean-reverting Ornstein-Uhlenbeck(OU) process, analytical trading strategies are obtained under a mean-variance(MV) framework. Model estimation and empirical studies on trading strategies have been conducted using data on pairs of stocks and futures traded on China’s securities market. These results indicate that pairs trading strategies have fairly good performance.
Highlights
Statistical arbitrage trading strategies have been widely used in financial markets
As reported by Liu and Timmermann (2013), convergence trades include merger arbitrage, pairs trading, on-the-run/off-the-run bond trades, tranched structured securities, and arbitrage between the same stocks trading in different markets
The dynamics for the price spread and the pairs trading strategies are described in a continuous-time modeling framework, as in Mudchanatongsuk et al (2008)
Summary
Statistical arbitrage trading strategies have been widely used in financial markets. The implementation of statistical arbitrage trading strategies may restrain excessive speculation, and enhance market liquidity. The expected utility framework has been studied widely in the context of the portfolio selection problem since the pioneering works of (Merton 1969, 1971) These two frameworks represent different investment preferences of various market participants, and have attracted considerable attention in the finance literature. Building on existing works such as Mudchanatongsuk et al (2008), Basak and Chabakauri (2010), Tourin and Yan (2013), and Gu et al (2020), an optimal trading strategy is formulated as a dynamic MV portfolio selection problem. To explore the potential implementation of the proposed approach, the empirical studies on the optimal trading strategies are conducted using data on pairs of stocks and futures traded on China securities market. The proofs and derivations of some results are provided in the “Appendix”
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