Loss protection in pairs trading through minimum profit bounds: A cointegration approach

Abstract

Pairs trading is a comparative-value form of statistical arbitrage designed to exploit temporary random departures from equilibrium pricing between two shares. However, the strategy is not riskless. Market events as well as poor statistical modeling and parameter estimation may all erode potential profits. Since conventional loss limiting trading strategies are costly, a preferable situation is to integrate loss limitation within the statistical modeling itself. This paper uses cointegration principles to develop a procedure that embeds a minimum profit condition within a pairs trading strategy. We derive the necessary conditions for such a procedure and then use them to define and implement a five-step procedure for identifying eligible trades. The statistical validity ofthe procedure is verified through simulation data. Practicality is tested through actual data. The results show that, at reasonable minimum profit levels, the protocol doesnot greatly reduce trade numbers or absolute profits relative to an unprotected trading strategy.