A good pair: alternative pairs-trading strategies

Abstract

This paper studies alternative techniques for identifying stock pairs in a pairs-trading strategy over 1980–2014.We consider two main techniques: the distance approach and the cointegration approach. We also consider a range of parameterizations of the trading system design. Parameterization of the trading system matters for the profitability of pairs trading.We find that the cointegration approach, despite using an optimal in-sample parameterization, yields significant returns only in the 1980s. The distance approach performs better, producing significantly positive risk-adjusted returns in all sub-periods. However, when transaction costs are properly taken into account, the returns largely disappear in recent years."