A Comprehensive Methodology for Pairs Trading Strategy and Performance Evaluation

Research Article
Open access

A Comprehensive Methodology for Pairs Trading Strategy and Performance Evaluation

Shizhuo Liao 1*
  • 1 Faculty of Arts and Sciences, University of Toronto, Toronto, Canada    
  • *corresponding author shizhuo.liao@mail.utoronto.ca
AEMPS Vol.191
ISSN (Print): 2754-1177
ISSN (Online): 2754-1169
ISBN (Print): 978-1-80590-189-1
ISBN (Online): 978-1-80590-190-7

Abstract

This study outlines some integrated approaches for pairs trading and portfolio analysis, focusing on the performance in generating consistent returns under varying market conditions over one year. The relationships between returns and some relevant factors are also explored. Steps for pairs trading involve selecting securities with strong historical associations or return correlations, normalizing their price series, calculating related price statistics, and employing a strategy based on Z-score to identify trading opportunities. Regression analysis of performance metrics across thousands of pairs highlights the significant relationship between the standard deviation of spread and profitability, whereas the return correlation is insignificant. The chosen portfolio exhibits low volatility, a high Sharpe ratio, and minimal drawdowns. Incorporating trading costs reveals a break-even point where the overall profit is zero. This confirms the strategy's robustness and real-world feasibility. In this paper, our result is against the weak form of the market efficiency theory, showing that strategies based on past information can generate consistent returns.

Keywords:

pairs trading, portfolio performance, Z-score strategy, trading costs, market efficiency

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References

[1]. Rad, H., Low, R. K. Y., & Faff, R. (2016). The profitability of pairs trading strategies: Distance, cointegration and copula methods. Quantitative Finance, 16(10), 1541–1558.

[2]. Gatev, E., Goetzmann, W. N., & Rouwenhorst, K. G. (2006). Pairs trading: Performance of a relative-value arbitrage rule. The Review of Financial Studies, 19(3), 797–827.

[3]. Jacobs, H., & Weber, M. (2015). On the determinants of pairs trading profitability. Journal of Financial Markets, 23, 75–97.

[4]. Perlin, M. (2009). Evaluation of pairs-trading strategy at the Brazilian financial market. Journal of Derivatives & Hedge Funds, 15(2), 122–136.

[5]. Luo, J., Lin, Y., & Wang, S. (2023). Intraday high-frequency pairs trading strategies for energy futures: Evidence from China. Applied Economics, 55(56), 6646–6660.

[6]. Do, B., & Faff, R. (2010). Does simple pairs trading still work? Financial Analysts Journal, 66(4), 83–95.

[7]. Brunetti, M., & De Luca, R. (2023). Pre-selection in cointegration-based pairs trading. Statistical Methods & Applications, 32, 1611–1640.

[8]. Wang, J., Rostoker, C., & Wagner, A. (2009). A high-performance pair trading application. 2009 IEEE International Symposium on Parallel & Distributed Processing, 1-8.

[9]. Zeng, Z., & Lee, C. G. (2014). Pairs trading: Optimal thresholds and profitability. Quantitative Finance, 14(11), 1881–1893.

[10]. Ramos-Requena, J. P., Trinidad-Segovia, J. E., & Sánchez-Granero, M. Á. (2020). Some notes on the formation of a pair in pairs trading. Mathematics, 8(3), 348.

[11]. Bowen, D. A., & Hutchinson, M. C. (2014). Pairs trading in the UK equity market: Risk and return. The European Journal of Finance, 22(14), 1363–1387.

[12]. Huck, N., & Afawubo, K. (2014). Pairs trading and selection methods: Is cointegration superior? Applied Economics, 47(6), 599–613.

[13]. Goetzmann, W., Ingersoll, J., Spiegel, M. I., & Welch, I. (2002). Sharpening Sharpe ratios. NBER Working Paper No. 9116. National Bureau of Economic Research.

[14]. Cogneau, P., & Hübner, G. (2009). The 101 ways to measure portfolio performance. Journal of Performance Measurement, 13(4), 56–71.

[15]. Bowen, D. A., Hutchinson, M. C., & O'Sullivan, N. (2010). High-frequency equity pairs trading: Transaction costs, speed of execution, and patterns in returns. Journal of Trading, 5(3), 31–38.

[16]. Do, B., & Faff, R. (2012). Are pairs trading profits robust to trading costs? Journal of Financial Research, 35, 261–287.

[17]. Keshavarz Haddad, G., & Talebi, H. (2023). The profitability of pair trading strategy in stock markets: Evidence from Toronto stock exchange. International Journal of Finance and Economics, 28(1), 193–207.

Cite this article

Liao,S. (2025). A Comprehensive Methodology for Pairs Trading Strategy and Performance Evaluation. Advances in Economics, Management and Political Sciences,191,53-65.

Data availability

The datasets used and/or analyzed during the current study will be available from the authors upon reasonable request.

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About volume

Volume title: Proceedings of ICEMGD 2025 Symposium: The 4th International Conference on Applied Economics and Policy Studies

ISBN：978-1-80590-189-1(Print) / 978-1-80590-190-7(Online)
Editor：Florian Marcel Nuţă , Xuezheng Qin
Conference website: https://www.icemgd.org/
Conference date: 20 September 2025
Series: Advances in Economics, Management and Political Sciences
Volume number: Vol.191
ISSN：2754-1169(Print) / 2754-1177(Online)

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References

[1]. Rad, H., Low, R. K. Y., & Faff, R. (2016). The profitability of pairs trading strategies: Distance, cointegration and copula methods. Quantitative Finance, 16(10), 1541–1558.

[2]. Gatev, E., Goetzmann, W. N., & Rouwenhorst, K. G. (2006). Pairs trading: Performance of a relative-value arbitrage rule. The Review of Financial Studies, 19(3), 797–827.

[3]. Jacobs, H., & Weber, M. (2015). On the determinants of pairs trading profitability. Journal of Financial Markets, 23, 75–97.

[4]. Perlin, M. (2009). Evaluation of pairs-trading strategy at the Brazilian financial market. Journal of Derivatives & Hedge Funds, 15(2), 122–136.

[5]. Luo, J., Lin, Y., & Wang, S. (2023). Intraday high-frequency pairs trading strategies for energy futures: Evidence from China. Applied Economics, 55(56), 6646–6660.

[6]. Do, B., & Faff, R. (2010). Does simple pairs trading still work? Financial Analysts Journal, 66(4), 83–95.

[7]. Brunetti, M., & De Luca, R. (2023). Pre-selection in cointegration-based pairs trading. Statistical Methods & Applications, 32, 1611–1640.

[8]. Wang, J., Rostoker, C., & Wagner, A. (2009). A high-performance pair trading application. 2009 IEEE International Symposium on Parallel & Distributed Processing, 1-8.

[9]. Zeng, Z., & Lee, C. G. (2014). Pairs trading: Optimal thresholds and profitability. Quantitative Finance, 14(11), 1881–1893.

[10]. Ramos-Requena, J. P., Trinidad-Segovia, J. E., & Sánchez-Granero, M. Á. (2020). Some notes on the formation of a pair in pairs trading. Mathematics, 8(3), 348.

[11]. Bowen, D. A., & Hutchinson, M. C. (2014). Pairs trading in the UK equity market: Risk and return. The European Journal of Finance, 22(14), 1363–1387.

[12]. Huck, N., & Afawubo, K. (2014). Pairs trading and selection methods: Is cointegration superior? Applied Economics, 47(6), 599–613.

[13]. Goetzmann, W., Ingersoll, J., Spiegel, M. I., & Welch, I. (2002). Sharpening Sharpe ratios. NBER Working Paper No. 9116. National Bureau of Economic Research.

[14]. Cogneau, P., & Hübner, G. (2009). The 101 ways to measure portfolio performance. Journal of Performance Measurement, 13(4), 56–71.

[15]. Bowen, D. A., Hutchinson, M. C., & O'Sullivan, N. (2010). High-frequency equity pairs trading: Transaction costs, speed of execution, and patterns in returns. Journal of Trading, 5(3), 31–38.

[16]. Do, B., & Faff, R. (2012). Are pairs trading profits robust to trading costs? Journal of Financial Research, 35, 261–287.

[17]. Keshavarz Haddad, G., & Talebi, H. (2023). The profitability of pair trading strategy in stock markets: Evidence from Toronto stock exchange. International Journal of Finance and Economics, 28(1), 193–207.

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