In previous articles in this series, we became acquainted with the nature of stock pair trading (link and link). We have learned that some 60 – 65% of transactions are profitable and that thanks to the number of trading opportunities, a trading portfolio with a 95% or even 99% likelihood of profit can be put together. The objective of this article is to inform you in detail about the process of building a portfolio of stock pairs and about the statistical approach to trading.
Basic premises in portfolio building
Stock pairs manifest a stable 60 – 65% of profitable transactions, at an RRR of 1:1. The frequency of trading is relatively low – about 10 – 15 transactions per pair in one year. Stock pairs offer a great number of trading opportunities (see the previous part of this series). Thanks to that, it is easy to achieve broad portfolio diversification. By nature, a stock pair is hedged against marked fluctuations, it is a market-neutral strategy. This property is further enhanced in the case of trading a pair portfolio. Trading can be fully automated, making it undemanding in terms of time (approximately 10 minutes before the markets close). This makes trading effortless from the psychological point of view. The risk of error due to stress, human error, or loss of self-control is low.
Stock pair equity
Adopting the hypothesis that the profitability of a strategy is based on a statistical advantage based on the very nature of stock-pair trading, we can consider all stock-pairs equal. In practice, it is becoming evident that certain stocks or sectors are more suitable for pair trading, but we will get to that in one of the future articles in this series.
Examples of the equity curves of several stock pairs:
Stock pair equity portfolios
If we combine several stock pairs in a portfolio, the total number of transactions will increase and the equity becomes significantly smoother (we are working with a larger sample of data):
Likelihood of putting together a profitable portfolio
The above is the cornerstone of the building of a stock pair portfolio. Given that an analysis of an extensive set of historical data has shown in a back test that XY% pairs (transactions) are profitable, we can put together a portfolio with an expected profitability approaching 100%. How do we do that?
Petr Tmej a Petr Slepička
Previous chapter: The edge of pair trading, profitability of the strategy
Next chapter: Searching and back-testing stock pairs