Cointegration-based pairs trading: identifying and exploiting similar exchange-traded funds

Abstract

We examine the effectiveness of pairs trading using ETFs from 2000 to 2024, focusing on how cointegration stability affects profitability and risk. Analyzing 30 ETF pairs with different z-score thresholds, we find that lowering the threshold increases trading opportunities, boosting profits and Sharpe ratios but also raising volatility and drawdowns. Short trading windows, where cointegration holds, limit long-term profitability. While pairs trading captures short-term arbitrage, its success depends on cointegration stability. The study emphasizes the need for adaptive strategies, better pairs selection, and strong risk management for sustained profitability in changing markets.