Pair Trading Strategy with ETFs: (Formula, Backtest, and Example)

Pair trading strategies with Exchange-Traded Funds (ETFs) are gaining traction among traders seeking to mitigate exposure to market fluctuations. While many traders primarily focus on individual stocks, ETFs offer a diversified approach to trading various segments of the stock market. In this article, we delve into the mechanics of an ETF pairs trading strategy, specifically targeting ETFs tracking major global indices such as the S&P 500, emerging markets, and specific country indices like Germany, the UK, and Japan.

This ETF Pairs trading strategy aims to capitalize on short-term market inefficiencies by going long on the weakest ETF and shorting the strongest one at the close, employing a market-neutral approach to trading. However, as we’ll explore further, implementing such a strategy comes with its own set of challenges and considerations.

Many traders are pair-trading ETFs. Pairs trading is one method of making your strategy less exposed to market fluctuations. Most traders trade stocks, but you can, of course, also trade ETFs. If you are trading ETFs you indirectly have a wide diversification, albeit to different segments of the stock market.

In this article, we look at an ETF pairs trading strategy. We go long the weakest ETF at the close and exit at the close the next day. It looks promising, but probably not a tradeable strategy. 

An ETF pairs trading strategy in SPY, EEM, EWG, EWU, and EWJ

Today we test ETF pairs trading.

This Sunday morning I was just testing some ideas on these different ETFs: SPY (S&P 500), EEM (emerging markets), EWG (Germany), EWU (UK), and EWJ (Japan). They seek to copy the performance of the most important stock exchanges in the world.

The rules of the pair trading strategy are like these:

  1. Every day rank each ETF based on the IBS formula: (c-l)/(h-l).
  2. Buy on the close the one with the lowest value, short the one with the highest value.
  3. Exit on the close next day.

In other words, this is a 100% “market-neutral” strategy – a daily pair trade in ETFs.

I write “market-neutral” because no strategy is ever completely neutral unless you’re doing arbitrage. Even though you have the same amount invested long and short, or at least adjusted to the expected volatility, you are still exposed to adverse movement in either position. You are liable to black swans.

The ETF pairs strategy returns this equity curve in %:

The test period is from 1. January 2005 until the present.  No commission and no slippage.

Does anyone trade something similar to this? Obviously, this one is hard to implement because the MOC needs to be sent 15 mins before close. However, for example in Amibroker you can easily program your strategies to send orders just seconds before the close:

The ETF pair trading strategy presented in this article is very short-term. This means it involves both commissions and slippage.

How does pairs trading work with ETFs?

Pair trading involves selecting two ETFs and taking opposite positions on them, typically going long on one and shorting the other. This strategy aims to capitalize on short-term market inefficiencies and reduce exposure to overall market fluctuations.

How do you rank ETFs in a pairs trading strategy?

In this strategy, ETFs are ranked daily using the IBS formula: (c-l)/(h-l), where ‘c’ is the closing price, ‘l’ is the lowest price, and ‘h’ is the highest price. The ETF with the lowest value is bought, while the one with the highest value is shorted.

What are the challenges associated with implementing a short-term ETF pairs trading strategy?

The short-term nature of this strategy introduces challenges such as commissions and slippage. These factors can impact overall returns and need to be considered when implementing the strategy. As it is, the strategy is not profitable as it is.

How can one effectively enter and exit positions in an ETF pairs trading strategy?

Entering and exiting positions at the close is crucial for this strategy. While it may require precise timing, some trading platforms allow for automated order placement shortly before the market closes, facilitating efficient execution of trades.

Is the ETF pairs trading strategy market-neutral?

Yes, the ETF pairs trading strategy is considered market-neutral. However, the article emphasizes that true market neutrality is challenging to achieve due to potential exposure to adverse movements in either position, even with an equal amount invested long and short.

How does the short-term nature of the ETF pairs trading strategy impact overall returns?

The article notes that the ETF pairs trading strategy is very short-term, involving both commissions and slippage. The FAQs address the impact of the strategy’s short-term nature on returns and highlight its potential implications for traders.

What are the advantages of trading ETF pairs compared to individual stocks?

Trading ETF pairs offers diversification across different segments of the stock market, providing exposure to multiple assets within a single trade. This diversification can help mitigate risk compared to trading individual stocks, which may be more susceptible to company-specific factors.

How does the choice of ETFs impact the effectiveness of a pairs trading strategy?

The effectiveness of a pairs trading strategy can be influenced by the selection of ETFs. Factors such as liquidity, correlation between the chosen ETFs, and market conditions can all play a role in determining the success of the strategy.

What risk management strategies should traders employ when implementing an ETF pairs trading strategy?

Risk management is essential when trading ETF pairs. Traders should consider implementing measures such as position sizing, setting stop-loss orders, and monitoring market conditions closely to mitigate potential losses and protect their capital.

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