Composition of portfolios by pairs trading with volatility criteria in the Brazilian market,

Abstract

The objective of this study was to understand how the shares’ volatility affects the portfolios’ dynamics formed using the model of pairs trading in the Brazilian stock market. This article distinguished itself by bringing new evidence about the effects of volatility in the pairs trading model not covered by previous studies, expanding the sample size analyzed in the Brazilian stock market. The chosen theme’s relevance is that investors can use pairs trading or long-short models to build their portfolios. The use of cointegration concepts probabilistically contributes to portfolios’ formation weakly correlated to the market indexes with superior performance. This article impacts the area by contributing new evidence for better use of the model in the analysis of investments. From January 2016 to December 2018, the 90 most liquid assets of Bolsa, Brasil, Balcão (B3) were analyzed, totaling 5,927,400 possible pairs. The Augmented Dickey-Fuller test and subsequent backtesting of the pairs in the proposed period were used to evaluate the cointegration criteria. Statistical analysis was performed by parametric and non-parametric tests and Pearson and Spearman correlation analyses. The results found indicated that the formation of portfolios by pairs trading with dependent assets with the criterion of higher levels of volatility (20 periods) presented a superior performance. These findings can be justified by a better risk and return ratio for the portfolio, measured by the Sharpe Index of the returns obtained concerning the portfolio’s volatility, compared to a portfolio formation based on a random selection of the pairs. In addition, the results also showed a low correlation of returns concerning the market index. Therefore, the application of the statistical cointegration analysis methodology alone does not guarantee results that are different from the market average.

An Entropic Approach for Pair Trading in PSX

“…Mean reversion allows traders to make a profit by matching a long position in one stock with an offsetting position in another stock [ 2 ]. Pair trading is an efficient method for the formation of portfolios or pair trading [ 3 , 4 ]; however, finding the accurate pairs and boundary points is not an easy task.…”

An Entropic Approach for Pair Trading in PSX

“…from two stocks to the formation of flexible portfolios and it is an efficient method for the formation of portfolios (Guerra Cavalcanti et al, 2021). However, this market-neutral trading strategy is neither riskneutral nor risk-free.…”