Pairs Trading with Copulas

Abstract

Pairs trading is a well-known speculative investment strategy, with the distance method the most commonly implemented variation. However, the profitability of this approach has decreased in recent years. This article seeks to generalize the pairs trading strategy using a copula technique to explicitly capture the marginal distributions as well as the dependency structure between the stock returns. With a better understanding of the joint distribution of the two stocks, practitioners could gain preferential entry positions and have more trading opportunities. The overall empirical results verify the proposed strategy’s ability to generate higher profits compared with the conventional distance method.

TOPICS: Statistical methods, security analysis and valuation