Pairs Trading Analysis

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Pairs Trading Analysis

• Global Asset Allocation
• Spring 2004
• The Hemline Theorists

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Pairs Trading Analysis

• Introduction
• Developing the Model
• Results

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Introduction

• Long/short, market- and industry-neutral strategy
• Pair selection criteria
• same industry
• mature companies
• long trading histories
• similar exposure to macro factors
• Assume reversion to historical value relationships

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Developing the Model

• Variable selection
• Stock price ratio
• Dividend yield ratio
• Selecting in-sample period and data frequency
• Daily data 1987-2004

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Pairs Trading Analysis Model Parameters

• Variables Switched on or off
• Deviation from mean historical ratio required for
  trade signal
• Translation of individual variable trade signals
  into overall trade signal

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Selecting Pairs Ford and GM
GM introduces its "GM10" family of newly
redesigned midsize cars. Restores profitability
through streamlined operations.
Ford announces highest earnings in auto industry
history
GM announces a restructuring of its North
American sales and marketing operations,
replacing marketing division-specific
organizations with a single sales
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Model Demonstration
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In-Sample Optimization

• Find the model parameters that
• Maximize average annual return on trade days
• Trade on at least 10 of total days
• Limit maximum drawdown to 15
• Sanity check to ensure model works over time and
  is currently valid

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Model Parameters
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In-Sample Results

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Out-of-Sample Results
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Extending the Model to Other Pairs
Eli Lilly Merck
Coca-Cola Pepsi
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Pairs Trading Analysis

• Questions?

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In Sample Optimization
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In Sample Optimization
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In Sample Optimization
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In Sample Optimization