Pairs Trading with Commodity Futures: Evidence from the Chinese Market

Abstract

In this study, the profitability of different pairs selection and spread trading methods are compared using the complete dataset of commodity futures from Dalian Commodity Exchange (DCE), Shanghai Futures Exchange (SHFE) and Zhengzhou Commodity Exchange (CZCE). Pairs trading methods that are already known in the literature are compared in terms of the risk-adjusted returns via in-sample and out-of-sample backtesting and bootstrapping for robustness. The empirical results show that pairs trading in the Chinese commodity futures market offers high returns, whereas, the profitability of these strategies primarily depends on the identification of suitable pairs. The observed high returns are a compensation for the spread divergence risk during the potentially longer holding periods, which implies that the maximum drawdown is more crucial compared to other risk-adjusted return measures such as the Sharpe ratio. Complementary to the existing literature, for our market, it is shown that if shorter maximum holding periods are introduced for the spread positions, then the pairs trading profits decrease. Therefore, the returns do not necessarily imply market inefficiency when the higher maximum drawdown associated with the holding period of the spread position is taken into account.