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Detecting Mean-Reverted Patterns in Algorithmic Pairs Trading

  • K. TriantafyllopoulosEmail author
  • S. Han
Conference paper
  • 2.6k Downloads
Part of the Springer Proceedings in Mathematics & Statistics book series (PROMS, volume 30)

Abstract

This paper proposes a methodology for detecting mean-reverted segments of data streams in algorithmic pairs trading. Considering a state-space model that describes the spread (data stream) as the difference of the prices of two assets, we propose two new recursive least squares (RLS) algorithms for predicting mean-reversion of the spread in real time. The first is a combination of steepest descent RLS and Gauss–Newton RLS, for which we extend previous work by providing exact recursive equations to update the variable forgetting factor (VFF). We propose a new RLS algorithm for variable forgetting, by transforming the prediction errors into a binary process and adopting Bayesian methods for inference. The new approach is versatile as compared to more traditional RLS schemes, having the advantage of uncertainty analysis around the VFF. The methods are illustrated with real data, consisting of daily prices of Target Corporation and Walmart Stores Inc shares, over a period of 6 years. Alongside the detection of mean-reversion of the spread, we implement a simple trading strategy. The empirical results suggest that the new Bayesian approach returns are in excess of 130% cumulative profit over a period of 2 years.

Keywords

Pairs trading Statistical arbitrage Mean-reversion Market-neutral trading Recursive least squares Variable forgetting factor Adaptive filtering 

Notes

Acknowledgements

The paper has benefitted from discussions with Jeremy Oakley.

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Copyright information

© Springer Science+Business Media New York 2013

Authors and Affiliations

  1. 1.School of Mathematics and StatisticsUniversity of SheffieldSheffieldUK

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