Copula Mispricing Index Signals for Dollar-Neutral Pairs Trading

Summary

This strategy uses copulas to estimate conditional probabilities between two assets’ daily returns. It accumulates each probability’s deviation from 0.5 into a mispricing index flag, intended to translate return dependence into a measure of how prices have moved apart. Thresholds on either asset’s flag generate equal-dollar long and short positions; exits occur when the triggering flag returns to zero or reaches a stop boundary, after which both flags reset.

The document discusses alternative rules requiring both signals to open a trade while allowing either to close it, and notes that this combination was less sensitive in the authors’ tests. It reports that the cited papers claimed 8–10% returns over a six-month formation period, but says the authors’ own implementation did not reproduce those returns across interpretations. Results depend strongly on entry and exit logic, parameter choices, input data, and copula selection; several signal conflicts are ambiguous in the source papers. The described performance claims therefore should not be treated as established or portable.

Key ideas

• The mispricing index is a copula-based conditional probability calculated from paired daily returns.
• Cumulative deviations of each index from 0.5 form flags intended to reflect how prices diverge over time.
• Flag thresholds trigger equal-dollar long and short positions, while flag resets follow exits.
• The document compares AND and OR entry and exit rules and reports that AND entry with OR exit was less sensitive in its tests.
• Reported returns from cited work were not reproduced by the document's authors, and results depend on implementation choices and data.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.