Pairs trading

Robert J. Elliott; John Van Der Hoek; William P. Malcolm

doi:10.1080/14697680500149370

Pairs trading

Robert J. Elliott, John Van Der Hoek^*, William P. Malcolm

^*Corresponding author for this work

Research output: Contribution to journal › Article › peer-review

233 Citations (Scopus)

Abstract

'Pairs Trading' is an investment strategy used by many Hedge Funds. Consider two similar stocks which trade at some spread. If the spread widens short the high stock and buy the low stock. As the spread narrows again to some equilibrium value, a profit results. This paper provides an analytical framework for such an investment strategy. We propose a meanreverting Gaussian Markov chain model for the spread which is observed in Gaussian noise. Predictions from the calibrated model are then compared with subsequent observations of the spread to determine appropriate investment decisions. The methodology has potential applications to generating wealth from any quantities in financial markets which are observed to be out of equilibrium.

Original language	English
Pages (from-to)	271-276
Number of pages	6
Journal	Quantitative Finance
Volume	5
Issue number	3
DOIs	https://doi.org/10.1080/14697680500149370
Publication status	Published - Jun 2005

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abstract = "'Pairs Trading' is an investment strategy used by many Hedge Funds. Consider two similar stocks which trade at some spread. If the spread widens short the high stock and buy the low stock. As the spread narrows again to some equilibrium value, a profit results. This paper provides an analytical framework for such an investment strategy. We propose a meanreverting Gaussian Markov chain model for the spread which is observed in Gaussian noise. Predictions from the calibrated model are then compared with subsequent observations of the spread to determine appropriate investment decisions. The methodology has potential applications to generating wealth from any quantities in financial markets which are observed to be out of equilibrium.",

keywords = "Hedge funds, Pairs trading, Spreads",

author = "Elliott, {Robert J.} and {Van Der Hoek}, John and Malcolm, {William P.}",

year = "2005",

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AU - Van Der Hoek, John

AU - Malcolm, William P.

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AB - 'Pairs Trading' is an investment strategy used by many Hedge Funds. Consider two similar stocks which trade at some spread. If the spread widens short the high stock and buy the low stock. As the spread narrows again to some equilibrium value, a profit results. This paper provides an analytical framework for such an investment strategy. We propose a meanreverting Gaussian Markov chain model for the spread which is observed in Gaussian noise. Predictions from the calibrated model are then compared with subsequent observations of the spread to determine appropriate investment decisions. The methodology has potential applications to generating wealth from any quantities in financial markets which are observed to be out of equilibrium.

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KW - Spreads

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VL - 5

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ER -

Pairs trading

Abstract

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