Pairs trading is a market neutral statistical arbitrage technique profiting from the correction of divergences in highly correlated pairs of assets. We found that trading single pairs of equities resulted in erratic and fleeting divergences that would be unable to trade on. We maximized our divergence time and optimized correctional behavior through identifying and trading on highly correlated bundles of equities with existing market indices.
Using mathematical relationships discovered with various measures of cointegration, we were able to construct bundles of index components that were cointegrated with the index itself. This pair of index ETF and synthetic bundle formed our pair in our statistical arbitrage framework. Our hypothesis was that the deviations from the mean of the spread between the two legs of our relatively unique, uncommon and creative pair could be exploited for riskless and significant profit (arbitrage).
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