PAIR TRADING STRATEGY IN INDIAN CAPITAL MARKET: Natural Pair(1)

For 73 natural pairs, trade signal wise generated no of trades are plotted to get the trend.

Trade signal Avg. No. of Trades
0.7/0.5 5.6
0.7/0.4 4.7
0.6/0.4 7.0
0.6/0.3 5.6
0.5/0.3 8.2
0.5/0.2 6.7
0.4/0.2 10.3
0.4/0.1 7.9
0.3/0.1 11.3

Table 3: Natural pair Avg No. of trades

All the 73 pairs are not found feasible for trading. Pairs with low correlation with the trading asset are having higher volatility and hence give uncertain return. So, a cut off correlation is derived for this segment, which is shown graphically below. The cut off correlation value is 0.78. For further analysis the pairs with correlation above 0.78 are only considered as they follow conventional risk-return relationship. 49 such pairs are found in this segment.

For these 49 pairs individual sample 2-tail t-test is done for each trading signal to check the statistical significance of the obtained returns. The test result includes mean return for each signal, standard deviation of each signal set, and t statistics. The test result is shown below:

One-Sample Statistics
Trade Signal N Mean Std. Deviation Std. Error Mean
0.7/0.5 49 7.657 15.660 2.237
0.7/0.4 49 8.798 25.224 3.603
0.6/0.4 49 4.247 6.465 0.924
0.6/0.3 49 3.423 2.907 0.415
0.5/0.3 49 2.378 1.878 0.268
0.5/0.2 49 2.460 1.783 0.255
0.4/0.2 49 1.961 2.071 0.296
0.4/0.1 49 2.369 3.464 0.495
0.3/0.1 49 1.410 1.163 0.166

Table .4: mean stat for natural pairs

One-Sample Test
Test Value = 0
TradeSignal T Df Sig.(2-tailed) MeanDifference 95% Confidence Interval of the Difference
Lower Upper
0.7/0.5 3.423 48 0.001 7.657 3.159 12.155
0.7/0.4 2.442 48 0.018 8.798 1.553 16.044
0.6/0.4 4.598 48 0.000 4.247 2.390 6.104
0.6/0.3 8.243 48 0.000 3.423 2.588 4.258
0.5/0.3 8.863 48 0.000 2.378 1.839 2.918
0.5/0.2 9.660 48 0.000 2.460 1.948 2.972
0.4/0.2 6.628 48 0.000 1.961 1.366 2.556
0.4/0.1 4.788 48 0.000 2.369 1.374 3.364
0.3/0.1 8.485 48 0.000 1.410 1.076 1.744

Table .5: t stat for natural pairs

For 48 degree of freedom t critical value (2 tailed) at 95% confidence level is 2.008. In the test result all the obtained t values are greater than the critical value, which suggests that the return series of every trade signal are statistically significant at 95% confidence level. In other words, it suggests that the average returns are feasible and reproducible in the future following the same trade signal.

This pair trading strategy return is statistically compared with the naive approach return. For the purpose the average of all signal return of every eligible pair is compared with the 1000 random simulation return from the NSE Index in the same time frame of the study. One way ANOVA testing has been done for mean comparison.

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