A Diversification Framework for Multiple Pairs Trading Strategies
A basic pairs trading strategy involves three main steps: (i) identification of assets, (ii) formation of spreads, and (iii) design of trading rules.
Existing studies only analyze the performance of trading a single pair, rather than the aggregate performance of multiple pairs.
There are several practical benefits of trading multiple pairs and considering them together in a trading program: (i) more spreads may give rise to more trading opportunities at any point in time; (ii) uncorrelated spreads may provide diversification benefits, and (iii) trading multiple pairs also opens up new doors for portfolio optimization, which does not exist when trading a single pair.
In our new paper*, we propose a novel framework for constructing diversified portfolios from multiple pairs trading strategies. Capital is allocated among different pairs based on the statistical characteristics, such as the speed of mean reversion and volatility, of the historical spreads.
Moreover, our approach is adaptive as portfolio weights are adjusted periodically. Among our allocation methods, we introduce the novel Mean Reversion Budgeting (MRB) and Mean Reversion Ranking (MRR) methods, which determine portfolio weights based on the speeds of mean reversion and other statistical…
