An Entropic Approach for Pair Trading in PSX

Abstract

The perception in pair trading is to recognize two stocks that move together, and their prices will converge to a mean value in future. However, finding the mean-reverted point at which the value of the pair will converge, and optimal boundaries of the trade is not easy. As uncertainty and model misspecifications may lead to losses. To cater for the problems, this study employs the novel entropic approach that utilizes entropy as penalty function for the misspecification of the model. The use of entropy as a measure of risk in pair trading is a nascent idea and this study utilizes daily data for 64 companies listed on PSX for the years 2017, 2018, and 2019, respectively to compute the returns based on the entropic approach. These companies cover the major sectors including Cement, Chemical, Automobile Assembler, Food and Personal Care Products, Oil and Gas Marketing Companies, Oil and Gas Exploration Companies Ltd, Power Generation and Distribution, Refinery and Pharmaceuticals. The returns to these stocks are then evaluated and compared with the Buy and Hold strategy. The results show positive and significant returns from pair trading using an entropic approach.