Advanced Pairs Trading: The Principal Component Analysis (PCA) Approach

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In this video, Illya Barziy, Quant Research Team Lead at Hudson and Thames, goes over the approach proposed in the paper "Statistical arbitrage in the US equities market"(2010) by Avellaneda, M. and Lee, J.-H. This strategy produced an annualized Sharpe ratio of 1.44 over the period from 1997 to 2007.

The idea is to decompose stocks returns into a systematic component and an idiosyncratic component (residual). In order to get the systematic component, the eigen portfolios from the PCA Approach are used.

The portfolio representing the idiosyncratic component can then be traded based on its deviation from equilibrium values.

We will briefly cover the theory behind the trading strategy, show its use examples with the ArbitrageLab package, discuss upsides, downsides, and variations of the strategy.

Links to slides: https://docs.google.com/presentation/...

Learn more with the Definitive Guide to Pairs Trading: https://hudsonthames.org/definitive-g...