A new approach to modeling and estimation for pairs trading

Pairs trading is an speculative investment strategy based on relative mispricing between a pair of stocks. Essentially, the strategy involves choosing a pair of stocks that historically move together. By taking a long-short position on this pair when they diverge, a profit will be made when they next converge to the mean by unwind-ing the position. Literature on this topic is rare due to its proprietary nature. Where it does exist, the strategies are either adhoc or applicable to special cases only, with little theoretical verification. This paper analyzes these existing methods in detail and proposes a general approach to modeling relative mispricing for pairs trading purposes, with reference to the mainstream asset pricing theory. Several estimation techniques are discussed and tested for state space formulation, with Expectation Maximization producing stable results. Initial empirical evidence shows clear mean reversion behavior in selected pairs ’ relative pricing