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Statistical Arbitrage and High-Frequency Data

with an Application to Eurostoxx 50 Equities

May 2010
Authors:
Christian L. Dunis
Gianluigi Giorgioni
Jason Laws
Jozef Rudy
Corresponding author and presenter :
Jozef Rudy
J.Rudy@2009.ljmu.ac.uk
Liverpool John Moores University
Outline
• Motivation

• Data used
– Data provider
– 2 types of data: HF and daily
– In- and out-of-sample periods

• Methodology
– Pair trading system
– Calculation of adaptive parameters
– Entry and exit points, stoploss

• Preliminary out-of-sample results


– Average trading results for all 176 pairs

• Further analysis
– Relation between in-sample information ratio, t-stat and out-of-sample information ratio

• Final results
– Results for 5 best pairs based on in-sample information ratio, t-stat
– Comparison with benchmarks
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Motivation
• Recent bad performance (see Gatev et al., 2006) of market
neutral strategies (see Vidyamurthy, 2004 for an
introduction)

• Technique developed in 1980 by Wall Street quant Nunzio


Tartaglia. Now a well-known technique (Alexander et al.,
2002, Burgess, 2003)

• Majority of trading ideas well-known across Wall Street. A


practical implementation and parameters make every
strategy “unique“ (Chan, 2009)

• Application of a pair trading strategy to equity HF/daily data


and comparison of the results (Nath (2003))
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Data used
• Eurostoxx 50 Equities:
– Daily data :3rd Jan 2000 – 17th Nov 2009
– Intraday data :3rd Jul 2009 – 17th Nov 2009
• Various intraday intervals: 5, 10, 20, 30 and 60 minutes

• Each share from 1 of 10 sectors: Basic Materials,


Communications, Consumer Cyclical, Consumer Non-
cyclical, Diversified, Energy, Financial, Industrial,
Technology and Utilities

• In- and Out-of-Sample Periods:

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Methodology I
• Pair trading model: zt  PY  t PX
t t
and pairs only from
the same industry

• Alternative approaches for beta calculation:

– fixed beta (calculated by OLS)


– moving window beta (calculated by rolling OLS)
– Double exponential - smoothing prediction model (DESP)
– Kalman filter - system and observation noise variances
constant (Bentz, 2003)

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Methodology II
• Genetic algorithm used to optimize:
– Rolling OLS: Length of the OLS rolling window optimized by
genetic algorithm
– DESP: Smoothing parameter and number of look-ahead
periods optimized by genetic algorithm
– Kalman filter: Signal/noise ratio (system/observation
noise) optimized by genetic algorithm

• Genetic optimization algorithm:


– Objective: maximization of the in-sample information ratio
– Started with 100 generations
– Mutation and crossover allowed
– Only 6 randomly chosen pairs optimized and these values
used for all the pairs

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Methodology III
• Spread generated by the pair trading model:
zt  z
– Normalized: nt 
sz

– z and sz calculated from the entire in-sample period


– Entry into the spread: abs(n )>2 t

– Exit from the spread: abs(n )<0.5t

– Stop loss not used

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Methodology in practice
• Bayer AG and Arcelor Mittal pair sampled at a 20-
minute interval
4 35%
Equity curve
3
30%
Value of the normalized spread

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1 25%

Cumulative Return
0
20%
-1
-2 15%

-3 Normalized spread
10%
Positions
-4
-5 5%

-6 0%
1 501 1001 1501 2001 1 501 1001 1501 2001
Time
Time

Normalized spread Cumulative equity curve

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Costs of trading
• Trading costs one-way for both shares (long
and short): 0.3%
– Transaction costs: 0.2% (0.1% * 2)
– Bid-ask spread: 0.1% (0.05% * 2)

• Net return calculation:


Rett  ln( PX t / PX t 1 )  ln( PYt / PYt 1 )  TC

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Preliminary out-of-sample results
• Results for different approaches:

• Detailed results for the Kalman filter approach:

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Some further analysis
• 95% confidence bounds for the correlation between in- and out-of-sample
information ratio

• 95% confidence bounds for the correlation between the in-sample t-stats
of the ADF test and out-of-sample information ratio

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Results after further analysis I
• 5 best pairs based on the in-sample information ratios:

• 5 best pairs based on the in-sample t-stat of the ADF test:

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Results after further analysis II
• 5 best pairs based on the in-sample t-stat (calculated from daily data)

• 5 best pairs based on the in-sample t-stat (calculated from daily frequency
data)

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Comparison with benchmarks
• Comparison of portfolio of 5 best pairs with benchmarks:

– Using HF data in the out-of-sample period (10 Sep – 17 Nov 2009)

– Using daily data in the out-of-sample period (1 Jan – 17 Nov 2009)

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References
• Alexander, C. and Dimitriu, A. (2002) The Cointegration Alpha: Enhanced Index
Tracking and Long-Short Equity Market Neutral Strategies. SSRN eLibrary,
http://ssrn.com/paper=315619
• Bentz, Y. (2003) Quantitative Equity Investment Management with Time-Varying
Factor Sensitivities. In Dunis, C., Laws, J. And Naïm, P. [eds.] Applied Quantitative
Methods for Trading and Investment. John Wiley & Sons, Chichester, 213-237.
• Burgess, A. N. (2003) Using Cointegration to Hedge and Trade International
Equities. In Dunis, C., Laws, J. And Naïm, P. [eds.] Applied Quantitative Methods for
Trading and Investment. John Wiley & Sons, Chichester, 41-69.
• Chan, E. (2009) Quantitative Trading: How to Build Your Own Algorithmic Trading
Business, John Wiley & Sons, Inc., New Jersey.
• Gatev, E., Goetzmann, W. N. and Rouwenhorst, K. G. (2006) Pairs Trading:
Performance of a Relative-Value Arbitrage Rule. The Review of Financial Studies.
19, 3, 797-827.
• Nath, P. (2003) High Frequency Pairs Trading with U.S. Treasury Securities: Risks
and Rewards for Hedge Funds. SSRN eLibrary, http://ssrn.com/paper=565441
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Thank you for your attention

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