Pair trading based on quantile forecasting of smooth transition GARCH models

Abstract

© 2016 Elsevier Inc. Pair trading is a statistical arbitrage strategy used on similar assets with dissimilar valuations. We utilize smooth transition heteroskedastic models with a second-order logistic function to generate trading entry and exit signals and suggest two pair trading strategies: the first uses the upper and lower threshold values in the proposed model as trading entry and exit signals, while the second strategy instead takes one-step-ahead quantile forecasts obtained from the same model. We employ Bayesian Markov chain Monte Carlo sampling methods for updating the estimates and quantile forecasts. As an illustration, we conduct a simulation study and empirical analysis of the daily stock returns of 36 stocks from U.S. stock markets. We use the minimum square distance method to select ten stock pairs, choose additional five pairs consisting of two companies in the same industrial sector, and then finally consider pair trading profits for two out-of-sample periods in 2014 within a six-month time frame as well as for the entire year. The proposed strategies yield average annualized returns of at least 35.5% without a transaction cost and at least 18.4% with a transaction cost.