Research on profit abilities of order placement strategies in pairs trading

Abstract

This paper discusses profit abilities of three pairs-trading strategies. When spreads of one pair reach an entry threshold, traders submit limit orders for one lowly liquid stock and market orders for the other highly liquid stock. In order to research on profit abilities, this paper models spreads of that pair of stocks as an Ornstein-Uhlenbeck (OU) process and supposes execution time of limit orders as a random variable independent of spreads of the pair. Strategy 1 is a traditional pairs-trading strategy with market orders. Inversely, strategies 2 and 3 are pairs-trading strategies related to limit orders. Finally, this research finds out that pairs-trading strategies with limit orders can beat pairs-trading strategies with market orders through an empirical experiment with real-world data. The contribution of this paper is to analyse three strategies and verify that strategy 3 has the best performance when the investment threshold is low. The results of this paper can help investors to make rational investment.