2. What is pair trading ?
Pairs trading is a market neutral trading strategy that matches a long and
short position in a pair of highly correlated instruments in between of two
stocks. The strategy’s profit is derived from the difference in price change
between the two instruments.
3. Why pair trading ?
• Due to market neutrality, this trading strategy can be very safe (if
diversified) and immune to global market crisis, even when the
entire market or sector falls down. If you trade enough pairs at the
same time, your pair trading portfolio could perform well also in
difficult market situations.
• Pairs trading is a form of mean reversion that has a distinct
advantage of always being hedged against market movements. It
is generally a high alpha strategy when backed up by some
rigorous statistics.
4. procedure
• Selection of sector
• High corelation stocks between two stocks
• Corelation must be nearest to 1 or between 0.8 to 1
• Co-intigration must be less than 0.05
• Augmented - dickey fuller test must be less than critical value of 10
percent
• Long or short above or below co-intigration line respectively
8. Augmented dickey fuller
• In statics and econometrics, an augmented Dickey–Fuller
test (ADF) tests the null hypothesis that a unit root is present in
a time series sample. The alternative hypothesis is different
depending on which version of the test is used, but is
usually stationarity or trend stationarity . It is an augmented version
of the Dickey Fuller test for a larger and more complicated set of
time series models.
• The augmented Dickey–Fuller (ADF) statistic, used in the test, is a
negative number. The more negative it is, the stronger the
rejection of the hypothesis that there is a unit root at some level of
confidence.
