Trading Strategies

1. Based on the Dicky-Fuller stationary test the pair is not a promising pair. The statistic is 2.51, which is not promising 2. 3. Pairs Trading Strategy

a. On the spread sheet columns E,F,G (PEP) and NOP(KO) are the various normalized N-day returns for the two stocks (N ranges from 5, 10, and 20 days). b. Column HIJ and QRS are c. Finally the differences between the z normalized returns are expressed in columns TUV (For example: T=zret5_pepsi minus zret5_coke). These are used find entry points and trade based on the spread. d. Trading on the spread means that when we go long the spread (Pepsi – Coke) it is equivalent to going long Pepsi and short Coke. When one of the stocks outperforms the other by a specific amount over a specific time period, you could short the outperformer and go long the underperformer with the expectation that prices will revert. e. Signal Column- If zdiff5 is less than the long entry threshold then long i.e 1, if zdiff is greater than short entry threshold then short i.e -1, if neither of the two then no signal i.e 0 f. Cap Column- If previous day’s position is long and zdiff5 > long cap then cap is hit. Vice versa for short position. g. Age Column- Age =1 if {(i) new signal and no previous position, (ii) flips position signal*previous position=-1, (iii) reach holding period limit and new signal is generated.} Age=0 if {(i) nothing happening and no previous position, (ii) hits cap, (iii) reached holding period and no new position.} Else, Age= Age+1

If((OR(AND(X9<>0,AC8=0),X9*AC8=1,AND($B$5=AA8,X9<>0),IF(OR(AND(AC8=0,X9=0),$B$5=AA8,OR(Y9=1,Z9=1)),0,AA8+1)))

h. Aged Column- If age limit is reached and new signal is generated then restart age at 0 i. Position Column- If there is no new signal and no caps and no Aged then position = carry of the previous position; otherwise position= the signal. This means that when columns x,y,z and ab are 0 then position = previous position, else position = signal.

4. Sharpe ratios with holding period 5 and profit target and equity graphs of the above strategies are included in the spreadsheet. We observe that the equity graphs criss-cross and provide good entry and exit signal. Thus, I would trade this strategy.