Pairs trading strategies are market-neutral long/short trading strategies designed to exploit short-term deviations from a long-run equilibrium pricing relationship between two assets. Typical pairs trading strategies include:

 
Co-integration is not the same as correlation:

Typical questions which must be answered when developing a pairs trading strategy include:

• How to identify trading pairs?
• When has the combined portfolio sufficiently moved from its equilibrium value to open a trading position?
• How much weight to assign for identified trading pairs in optimal portfolio?
• When do we close the position?

From a risk management perspective, it is also important to specify maximum
allowable time to maintain open trading positions, maximum allowable Value at Risk (VaR), and further possible risk reducing measures such as stop-loss triggers.

We use the Johansen test for co-integration to select trading pairs:

• A long-run equilibrium price relationship is estimated for the identified trading pairs
• The resulting mean-reverting residual spread is modeled as a Vector-Error-Correction model (VECM)
• Transitory form of VECM:



• Johansen test is more appropriate than Engle-Granger test

We focus on trading pairs exhibiting:

• A high mean reversion rate to each other, i.e. trading pairs which are “tied together” by a long term common trend
• A high volatility, i.e. the ability to deviate from this trend from time to time!

• Fundamental analysis shows that gas, oil, power prices are driven by similar risk factors.
• Other commodity products may not exhibit an intuitive relationship but are also included in the investment space.
• We use futures contracts in energy, metal and agricultural products to ensure sufficient liquidity and decrease friction costs.
• Futures maturities range from 1-month to 3-years ahead

The main risk exposure to commodity specific events:

• Fundamental changes that imply prices may never mean-revert again, or at least not within 15 days.
• In order to control this risk, rules of stop-loss and a maximum holding period are used.
• This risk is further reduced through diversification, which is obtained by simultaneously investing in several pairs (with a maximum of 10 pairs).
• There is a risk that the trading game may not last long enough.
• It might be the case that the strategy is successful in the long run, but that a few short run failures will ruin the overall excess return possibilities.

Trading and risk management rules should be defined and adhered to as follows:

• Open a position when the ratio of two product prices hits a calibrated threshold and close it when the ratio returns to the mean. The position is not opened when the ratio breaks the two-standard-deviations limit for the first time, but rather when it crosses it to revert to the mean again.
• A maximum number of traded pairs is defined. Portfolio weights are proportional to the mean-reversion coefficient.
• Maximum holding period is to be calibrated based on mean-reversion rate.
• If the ratio develops in an unfavorable way, stop-loss is triggered to close the position if loss exceeds a pre-defined amount of the initial size of the position.

 
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