An Approach to Modeling Pair Trading: Stochastic Spread Method (Part I)

Abstract

Among all kinds of quantitative methods of speculation, pair-trading strategy is one of the popular short-term speculation strategies. In more than 20 years of operation, pair-trading strategy is widely used in hedge funds and investment banks; even more, it has been used as a statistical arbitrage tool in financial industry. Pair-trading strategy is built on a simple model of two stocks with the similar price movement. When the correlation between the two stocks is weak, short the winner stock and long the lower priced stock. On the other hand, the pair trading system has been used on the equities between industries as well. The paper explores the pair trading by using stochastic spread method in details. The main focus of the paper is the state process of stochastic spread model.

Introduction

Pair trading is an investment strategy of speculation used in Wall Street since the middle of 1980s (Vidyamurthy, 2004). It takes advantages of any disturbance over a pair of financial instruments. Traders form a portfolio with two stocks that have historically moved together and kept a specific pattern on their spread. The actions are taken at the place the spread away from “equilibrium” state, such as the mispricing on a pair of similar stocks, and when the market experience on a fluctuated condition. By longing the relatively undervalued asset and shorting on the relatively overvalued asset, the trader may earn a great profit by unwinding the position when the spread is convergent. The strategy has been widely used in hedge funds and investment banks, as well as a statistical arbitrage tool in financial industry.

Pair trading used to take the form of statistical arbitrage in definition (Vidyamurthy, 2004). Statistical arbitrage refers to using time series methods to select the possible mispricing pairs of stock, and takes actions based on the modeling and forecasting of the spread between the pair. On the other hand, pair trading also takes the form of risk...