Selecting Pairs for Trading with Time-Varying Lead-Lag Relationships

Summary

The study proposes a stock-pair selection distance measure that accounts for lead-lag relationships between the two stocks. It starts from the observation that correlated securities may not move simultaneously: one can tend to respond before the other. Earlier pair-selection measures did not incorporate this timing relationship. The proposed measure also allows the estimated lead-lag value to change continuously over time, aiming to represent relationships that are not fixed.

The authors test the approach using datasets of Indian and American companies. They report that selecting pairs by combining the new measure with the sum of squared differences (SSD) consistently produces the best profits among the measures compared. This is evidence from the study’s experiments, rather than a guarantee of profitability in live trading. The supplied description does not state the sample periods, transaction-cost assumptions, trading rules, or statistical uncertainty, all of which would matter when judging whether the reported performance generalizes.

Key ideas

• A pair-selection measure can incorporate which stock tends to lead or lag the other.
• The proposed lead-lag relationship is allowed to vary over time.
• The study tests its measure on datasets of Indian and American companies.
• Combining the new measure with SSD is reported to produce the strongest profits in the experiments.
• The description omits implementation and evaluation details such as costs and sample periods, limiting conclusions about live performance.

Tags

# Selecting stock pairs for pairs trading while incorporating lead-lag relationship


# Selecting stock pairs for pairs trading while incorporating lead-lag relationship









Pairs Trading is carried out in the financial market to earn huge profits from known equilibrium relation between pairs of stock. In financial markets, seldom it is seen that stock pairs are correlated at particular lead or lag. This lead-lag relationship has been empirically studied in various financial markets. Earlier research works have suggested various measures for identifying the best pairs for pairs trading, but they do not consider this lead-lag effect. The present study proposes a new distance measure which incorporates the lead-lag relationship between the stocks while selecting the best pairs for pairs trading. Further, the lead-lag value between the stocks is allowed to vary continuously over time. The proposed measures importance has been show-cased through experimentation on two different datasets, one corresponding to Indian companies and another corresponding to American companies. When the proposed measure is clubbed with SSD measure, i.e., when pairs are identified through optimising both these measures, then the selected pairs consistently generate the best profit, as compared to all other measures. Finally, possible generalisation and extension of the proposed distance measure have been discussed.

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