Designing Efficient Pair-Trading Strategies Using Cointegration for the Indian Stock Market

TL;DR

This paper develops a cointegration-based pair-trading strategy for the Indian stock market, identifying profitable stock pairs across sectors and evaluating their performance using historical data from 2018 to 2021.

Contribution

It introduces a sector-wise cointegration approach for pair selection and assesses its effectiveness in the Indian stock market context.

Findings

Auto and realty sector pairs yielded highest returns.

Some IT sector pairs resulted in negative returns.

The approach effectively identified profitable pairs.

Abstract

A pair-trading strategy is an approach that utilizes the fluctuations between prices of a pair of stocks in a short-term time frame, while in the long-term the pair may exhibit a strong association and co-movement pattern. When the prices of the stocks exhibit significant divergence, the shares of the stock that gains in price are sold (a short strategy) while the shares of the other stock whose price falls are bought (a long strategy). This paper presents a cointegration-based approach that identifies stocks listed in the five sectors of the National Stock Exchange (NSE) of India for designing efficient pair-trading portfolios. Based on the stock prices from Jan 1, 2018, to Dec 31, 2020, the cointegrated stocks are identified and the pairs are formed. The pair-trading portfolios are evaluated on their annual returns for the year 2021. The results show that the pairs of stocks from the auto and the realty sectors, in general, yielded the highest returns among the five sectors studied in the work. However, two among the five pairs from the information technology (IT) sector are found to have yielded negative returns.