An Application of the Ornstein-Uhlenbeck Process to Pairs Trading

TL;DR

This paper explores using the Ornstein-Uhlenbeck process for pairs trading, comparing it to a naive rolling window approach, and finds it captures signals well but underperforms in risk-return due to non-stationarity.

Contribution

It introduces an OU process-based model for pairs trading and compares its effectiveness to traditional methods, highlighting its strengths and limitations.

Findings

OU model captures signals and trends effectively

OU model underperforms naive approach on risk-return

Non-stationarity affects model performance

Abstract

We conduct a preliminary analysis of a pairs trading strategy using the Ornstein-Uhlenbeck (OU) process to model stock price spreads. We compare this approach to a naive pairs trading strategy that uses a rolling window to calculate mean and standard deviation parameters. Our findings suggest that the OU model captures signals and trends effectively but underperforms the naive model on a risk-return basis, likely due to non-stationary pairs and parameter tuning limitations.