Skip to content
All library documents

Selecting Pairs for Relative-Value Trading with Economic Rationale

Article Quant Q&A · Author: Good Guy Mike
Read the original

Summary

The document surveys ways to identify candidate pairs for a pairs-trading strategy. It describes a statistical route—searching across instruments for correlated price movements—and names cointegration as a commonly discussed selection approach. It also recommends beginning with an economic explanation for why two instruments should move together, then checking whether their historical prices support that relationship.

Examples include stocks in the same industry, related industries or indices, a stock paired with its industry exchange-traded fund, and an exchange rate paired with an equity index or stock. The answer warns that a correlation found by brute-force screening may be data-mining noise, and that a genuine company-specific news event can explain why one leg moves alone and may be a reason to skip a trade. The discussion is introductory: it provides search directions and qualitative judgment criteria, but no formal selection algorithm, thresholds, evidence of profitability, or detailed treatment of forecasting-based methods.

Key ideas

  • Pairs trading seeks instruments whose prices have historically moved together and may return to alignment after diverging.
  • Candidate pairs can be screened statistically using correlation or cointegration methods.
  • An economic explanation for the relationship helps distinguish plausible pairs from spurious historical matches.
  • Related firms, industries, indices, sector funds, and currency-equity combinations are possible pair candidates.
  • Company-specific news can justify avoiding a trade even when a pair’s prices diverge.

Tags

Pairs tradingEquitiesStatisticsMean reversion
Full text
# What different methods of pairs selection exists? (For Pairs trading)


# What different methods of pairs selection exists? (For Pairs trading)












(I'm quite new to quant finance so I'm not sure if this is an eligible question.)

I've decided I want to backtest pairs trading on the Nordic stockmarket. So I would guess there exists different methods of selecting the pairs (not just guess, I've heard and read some about them). For example the 'most written about' selection based on cointegration which seems most straight forward (which was used by Gatev et al in their paper called Pairs Trading: Performance of a Relative-Value Arbitrage Rule), but also some extended versions of this based on forecasting (tried reading about it but it was a bit to advanced for me). I've also heard about pairs trading calender time (or something like that), which I tried to find some articles about without succeeding (my guess would be that the selection and trades are done 'in calender time', meaning they are based on opening/closing prices rather than intraday. Please correct me if I'm wrong).

So my question is basically what different methods of pairs selection exists? I wouldn't want a full description of them, just some keywords to search (it's hard to find something when you don't really know what you're looking for.. sort of).

Maybe if someone has come across some recent finding in this area or if someone who is actually working with this could give me some ideas on what is 'hot' (meaning what is used in the industry today) it would be great. I tried to contact a few hedgefunds, however they didn't really have time for students (maybe it was naive of me think they would).

Thank you in advance for your help!

## Answer by Darren Cook (score 6)

https://quant.stackexchange.com/a/7274

The basic idea of pair trading is to find two symbols (I'll use that to mean stocks, futures, anything you can trade) that historically have correlated price movements. Then if just one of them increases in price you short that symbol, and buy its pair, on the assumption that they will soon go back in sync.

However when you think there is a genuine reason for just one to move then you skip the trade; this is why trading stocks is nice, as most of the time when one stock moves but its pair does not, it is due to some news item. You can then quickly make a judgement how stock-specific it is (E.g. BP and the Deepwater accident affected BP more than SHEL).

You can find candidates with brute force: run correlations between all pairs of symbols in your database. But once you've found the correlation the next step is to find a story. An explanation for why their prices move in step. Without that you won't know when to ignore a move. If you cannot find a story either you have discovered data mining noise, or you haven't tried hard enough.

That is why usually you find pairs by starting with the story, and then looking for a correlation:

- Two stocks in the same industry. The Wikipedia page has a few stock examples.

- Two industries or stock market indices that have a lot in common. E.g. FTSE100 and FTSE250 correlate fairly well, because both are driven by the same general economic news.

- You might also consider pair-trading one stock with its industry ETF.

- You might even consider pairing an exchange rate with a stock or an index. E.g. the Nikkei 225 and USD/JPY. The story there being that as the yen weakens the big manufacturers become more competitive overseas. However raw material costs, in yen terms, also go up, so there is a counter-story there too.

IIRC, Ernie Chan's Quantitative Trading book had a chapter on pair trading.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

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