Cointegration-Based Pair Trading in Indian Equities

Summary

The paper describes a method for constructing pairs trades among stocks in five sectors of India’s National Stock Exchange. It uses cointegration to identify stocks with a long-run association, then forms portfolios intended to trade short-term price divergence: short the stock that has risen and buy the one that has fallen. The stock prices used to identify cointegrated pairs cover January 2018 through December 2020.

The portfolios are evaluated using annual returns for 2021. The reported results indicate that auto and realty sector pairs generally produced the highest returns among the sectors studied, while two of the five information technology pairs had negative returns. These findings are limited to the selected stocks, sectors, sample period, and evaluation year described. The excerpt does not state transaction costs, risk-adjusted performance, or whether the relationships persisted beyond the test period, so it does not establish broad or durable profitability.

Key ideas

• Cointegration is used to identify potentially related NSE stocks for pairs trading.
• The approach trades divergence by shorting the rising stock and buying the falling stock.
• Pair selection uses prices from January 2018 through December 2020, with portfolio returns assessed for 2021.
• Auto and realty pairs generally performed best among the sectors examined.
• Two of the five information technology pairs reportedly had negative returns.

Tags

# Designing Efficient Pair-Trading Strategies Using Cointegration for the Indian Stock Market


# Designing Efficient Pair-Trading Strategies Using Cointegration for the Indian Stock Market









A pair-trading strategy is an approach that utilizes the fluctuations between prices of a pair of stocks in a short-term time frame, while in the long-term the pair may exhibit a strong association and co-movement pattern. When the prices of the stocks exhibit significant divergence, the shares of the stock that gains in price are sold (a short strategy) while the shares of the other stock whose price falls are bought (a long strategy). This paper presents a cointegration-based approach that identifies stocks listed in the five sectors of the National Stock Exchange (NSE) of India for designing efficient pair-trading portfolios. Based on the stock prices from Jan 1, 2018, to Dec 31, 2020, the cointegrated stocks are identified and the pairs are formed. The pair-trading portfolios are evaluated on their annual returns for the year 2021. The results show that the pairs of stocks from the auto and the realty sectors, in general, yielded the highest returns among the five sectors studied in the work. However, two among the five pairs from the information technology (IT) sector are found to have yielded negative returns.

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