Original Research

Trading strategies with copulas

Yolanda Stander, Daniël Marais, Ilse Botha
Journal of Economic and Financial Sciences | Vol 6, No 1 | a278 | DOI: https://doi.org/10.4102/jef.v6i1.278 | © 2018 Yolanda Stander, Daniël Marais, Ilse Botha | This work is licensed under CC Attribution 4.0
Submitted: 27 June 2018 | Published: 30 April 2013

About the author(s)

Yolanda Stander, Faculty of Economics and Financial Sciences, University of Johannesburg, South Africa
Daniël Marais, Department of Economics and Econometrics, University of Johannesburg, South Africa
Ilse Botha, Department of Finance and Investment Management, University of Johannesburg, South Africa

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Abstract

A new approach is proposed to identify trading opportunities in the equity market by using the information contained in the bivariate dependence structure of two equities. The relationships between the equity pairs are modelled with bivariate copulas and the fitted copula structures are utilised to identify the trading opportunities. Two trading strategies are considered that take advantage of the relative mispricing between a pair of correlated stocks and involve taking a position on the stocks when they diverge from their historical relationship. The position is then reversed when the two stocks revert to their historical relationship. Only stock-pairs with relatively high correlations are considered. The dependence structures of the chosen stock-pairs very often exhibited both upper- and lower-tail dependence, which implies that copulas with the correct characteristics should be more effective than the more traditional approaches typically applied. To identify trading opportunities, the conditional copula functions are used to derive confidence intervals for the two stocks. It is shown that the number of trading opportunities is highly dependent on the confidence level and it is argued that the chosen confidence level should take the strength of the dependence between the two stocks into account. The backtest results of the pairs-trading strategy are disappointing in that even though the strategy leads to profits in most cases, the profits are largely consumed by the trading costs. The second trading strategy entails using single stock futures and it is shown to have more potential as a statistical arbitrage approach to construct a portfolio.

Keywords

copulas; pairs-trading; single stock futures; mean reversion; stock price drift; trading costs; backtest; hedge funds; statistical arbitrage

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