WITHDRAWN A Bayesian approach to generate distribution-based trading signals in pairs trading

Music City Center 

We introduce a novel approach to generating more precise and adaptive trading signals in pairs trading. The method consists of deriving the full conditional distribution of the hedge ratio (ß1) and using its quantiles as confirmation thresholds for trading signals originated in the standard cointegration strategy. We applied the method to selected pairs of assets across the various markets. The empirical analysis demonstrated that the proposed algorithm significantly enhances trading performance and risk management for several pairs compared to the traditional cointegration method. By adopting a distribution-based framework through Bayesian hierarchical modeling, our method not only enables more timely trading signals but also improves pair selection by effectively detecting a considerable proportion of false positives in cointegration tests as demonstrated via simulations.