We offer the most complete product innovation in the Pairs Trading Institution
“Pairs Trading: Performance of a Relative-Value Arbitrage Rule”, The Review of Financial Studies, 19 (2006) 797-827, by Gatev, Goetzmann, Rouwenhorst. They tested a simple pairs trading strategy on daily data from 1962-2002. A simple trading rule yields average annualized excess returns of up to 11% for self-financing portfolios of pairs. We will look at their results as a model for a careful back testing analysis of a trading strategy. Pairs were formed based on price correlations over a 12-month period, starting every month. Each pair was then traded (possibly multiple times) over the next six months. The pair was “bought” when its ratio spread was outside two standard deviations of its 12-month spread. If normally distributed, this should happen about 5% of the time.
- Part 1: Overview
- Part 2: Academic studies
- Part 3: Working example
- Part 4: In Practice