Performance of Pairs Trading Strategies Based on Various Copula Methods

This study evaluates three pairs trading strategies—the distance method (DM), mispricing index (MPI) copula, and mixed copula—across the Chinese equity market from 2005 to 2024, incorporating time-varying transaction costs. To enhance computational efficiency, a novel two-step methodology is proposed that first selects candidate pairs based on the sum of squared differences and then applies copula models to capture nonlinear and asymmetric dependence structures between stocks. Pre-cost monthly excess returns are 84, 30, and 25 basis points, respectively, dropping to 81, 23, and 15 basis points post-costs. While the DM consistently delivers higher returns, copula strategies offer advantages in stability and resilience, especially in volatile markets. The Student-t copula proves particularly effective in capturing dependence structures with fat tails and asymmetric correlations. Although copula methods face challenges such as unconverged trades—instances where spreads fail to revert within the trading horizon—they nonetheless highlight the diversification and risk mitigation potential of advanced dependence-based approaches. Enhancing trade convergence and controlling downside risk could further improve copula strategy performance. Overall, the results highlight the diversification and risk mitigation potential of advanced copula-based pairs trading models under dynamic market conditions.