Selecting stock pairs for pairs trading while incorporating lead–lag relationship

Abstract

Pairs Trading is carried out in the financial market to earn huge profits from any known equilibrium relation between a pair of stock. In financial markets, seldom it is seen that stock pairs are correlated at particular lead or lag. This lead–lag relationship has been empirically studied in various financial markets. Earlier research works have suggested some measures for identifying the best pairs for pairs trading, but they do not consider this lead–lag effect. The present study proposes a new distance measure which incorporates the lead–lag relationship between the stocks while selecting the best pairs for pairs trading. Further, the lead–lag value between the stocks is allowed to vary continuously over time. The importance of the measure has been show-cased through experimentation on three different datasets, consisting of Indian, American and Japanese companies. When the proposed measure is clubbed with SSD measure, i.e., when pairs are identified through optimising both these measures, then the selected pairs consistently generate the best profit, as compared to all other measures. Finally, possible generalisation and extension of the proposed distance measure have been discussed.