An Entropic Approach for Pair Trading in PSX

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.