Abstract:
This study focuses on the derivation of the optimal boundary for pair trading. This boundary
defines the points of entry into or exit from the market for a given stock pair. However, if the
assumed model contains uncertainty, the resulting boundary could result in large losses. To avoid
this, we develop a more robust strategy by accounting for the model uncertainty. To incorporate
the model uncertainty, we use the relative entropy as a penalty function in the expected profit from
pair trading. A 64 companies stock data is taken from Pakistan stock exchange (PSX) for the years
2017, 2018 and 2019 to evaluate these optimal boundary points. The returns to these stocks are
then evaluated and compared with Buy and Hold strategy. The results show positive and significant
returns from pair trading using entropic approach.
