On the Profitability of Optimal Mean Reversion Trading Strategies

TL;DR

This paper develops an optimal mean reversion trading strategy using maximum likelihood estimation of the Ornstein-Uhlenbeck process, demonstrating high Sharpe ratios in both in-sample and out-of-sample tests on US equity pairs.

Contribution

It introduces a rigorous method for constructing and testing mean reversion pairs trading portfolios based on maximum likelihood estimation of the Ornstein-Uhlenbeck process, improving robustness.

Findings

High Sharpe ratios achieved in multiple pairs (above 1.9).

Consistent out-of-sample performance confirms strategy robustness.

Specific pairs like CCI-HCP and CCI-O show Sharpe ratios over 2.4.

Abstract

We study the profitability of optimal mean reversion trading strategies in the US equity market. Different from regular pair trading practice, we apply maximum likelihood method to construct the optimal static pairs trading portfolio that best fits the Ornstein-Uhlenbeck process, and rigorously estimate the parameters. Therefore, we ensure that our portfolios match the mean-reverting process before trading. We then generate contrarian trading signals using the model parameters. We also optimize the thresholds and the length of in-sample period by multiple tests. In nine good pair examples, we can see that our pairs exhibit high Sharpe ratio (above 1.9) over the in-sample period and out-of-sample period. In particular, Crown Castle International Corp. (CCI) and HCP, Inc. (HCP) achieve a Sharpe ratio of 2.326 during in-sample period and a Sharpe ratio of 2.425 in out-of-sample test. Crown Castle International Corp. (CCI) and Realty Income Corporation (O) achieve a Sharpe ratio of 2.405 and 2.903 respectively during in-sample period and out-of-sample period.