Which Pairs of Stocks should we Trade? Selection of Pairs for Statistical Arbitrage and Pairs Trading in Karachi Stock Exchange

Abstract

Pairs Trading refers to a statistical arbitrage approach devised to take advantage from short term fluctuations simultaneously depicted by two stocks from long run equilibrium position. In this study a technique has been designed for the selection of pairs for pairs trading strategy. Engle-Granger 2-step Cointegration approach has been applied for identifying the trading pairs. The data employed in this study comprised of daily stock prices of Commercial Banks and Financial Services Sector. Restricted pairs have been formed out of highly liquid log share price series of 22 Commercial Banks and 19 Financial Services companies listed on Karachi Stock Exchange. Sample time period extended from November 2, 2009 to June 28, 2013 having total 911 observations for each share prices series incorporated in the study. Out of 231 pairs of commercial banks 25 were found cointegrated whereas 40 cointegrated pairs were identified among 156 pairs formed in Financial Services Sector. Furthermore a Cointegration relationship was estimated by regressing one stock price series on another, whereas the order of regression is accessed through Granger Causality Test. The mean reverting residual of Cointegration regression is modeled through the Vector Error Correction Model in order to assess the speed of adjustment coefficient for the statistical arbitrage opportunity. The findings of the study depict that the cointegrated stocks can be combined linearly in a long/short portfolio having stationary dynamics. Although for the given strategy profitability has not been assessed in this study yet the VECM results for residual series show significant deviations around the mean which identify the statistical arbitrage opportunity and ensure profitability of the pairs trading strategy. JEL classifications: C32, C53, G17 Keywords: Pairs Trading, Statistical Arbitrage, Engle-Granger 2-step Cointegration Approach, VECM.

Comparative Study of Pair Trading Techniques in Pakistan’s Financial and Non-Financial Sector

“…Under the full short-selling restriction, all strategies, except the Hurst exponent approach, produce larger returns, with the cointegration method performing the best. In Pakistan's context, Qazi et al (2015) employed the Engle-Granger two-step tests of cointegration on commercial banks and the financial services sector listed on the Karachi Stock Exchange. The findings of this study showed that a linear short/long portfolio may be constructed from equities that are cointegrated and follow stationary dynamics.…”

“…Similarly, Table 2 showed mean, median and mode values along with max, min, and standard deviation of data from the central point under the cointegration method for both sectors, results illustrated that again both sectors had positive average values with the highest average returns of 0.0684 if portfolio consists of top 5 pairs in the non-financial sector. These findings are consistent with previous pair trading research in Pakistan, such as (Shaukat et al, 2021;Sohail., Sindhu & Imran., 2020;Qazi et al, 2015).…”

“…Finally, under the co-integration technique, again both sectors of the Pakistan stock exchange show favorable significant outcomes, but non-financial enterprises had comparatively the best returns as in the distance method. These results of pair trading strategies are also authenticating the profitability in accordance with the results of other studies like (Namwong, Yamaka, & Tansuchat., 2019;Sohail, Sindhu & Imran., 2020;Qazi et al, 2015).…”

“…Numerous pair trading strategies are therefore ineffective when applied directly to these emerging stock markets. So Pakistan which is our native country, only a few studies on pair trading have been done in Pakistan; for instance, in the study of Qazi et al (2015) no trading algorithm was used and only pairings were created from the financial service sector, and commercial banks listed on Karachi stock exchange. studied the co-integration approach to calculate the profitability of pair trading by taking the daily data from three industries textiles, chemicals, and banking from 2011 to 2019.…”

An Entropic Approach for Pair Trading in PSX

“…In context of Pakistan, there are handful of studies conducted on pair trading (Qazi et al, 2015;Sohail et al, 2020) and interestingly no one has considered the optimal stopping problem using stocks listed on Pakistan Stock Exchange (PSX). This study employs the novel entropic approach to explore the optimal boundary points that yield maximum profit for 64 companies listed on Pakistan Stock Exchange (PSX) for the period 2017-2019.…”