Sector-Based Pairs Trading Strategy With Novel Pair Selection Technique

Abstract

A pair trading strategy (PTS) is a balanced approach that involves simultaneous trading of two highly correlated stocks. This article introduces the PTS-return-based pair selection (PTS-R) strategy which is the modification of the traditional PTS. The PTS-R follows a similar framework to the traditional PTS, differing only in the criteria it employs for selecting stock pairs. Moreover, this article proposes a novel trading strategy called sector-based pairs trading strategy (SBPTS) along with its two variants, namely SBPTS-correlation-based pair selection (SBPTS-C) and SBPTS-return-based pair selection (SBPTS-R). The SBPTS focuses on the pairs of stocks within the same sector. It consists of three innovative phases: the classification of input stocks into the respective sectors, the identification of the best-performing sector, and the selection of stock pairs based on their returns. The goal is to identify the pairs with a strong historical correlation and the highest returns within the best-performing sector. These chosen pairs are then used for trading. The strategies are designed to enhance the efficacy of the pairs trading and are validated through experimentation on real-world stock data over a ten-year historical period from 2013 to 2023. The results demonstrate their effectiveness compared to the existing techniques for pair selection and trading strategy.