This article is the final project submitted by the author as a part of his coursework in Executive Programme in Algorithmic Trading (EPAT™) at QuantInsti®. Do check our Projects page and have a look at what our students are building.

**About the Author**

**Xing Tao** is a Bachelor in Computer Science (LZU), Masters in Information System and Management Science (PKU), and has passed CFA level 1-3 exams. Presently, he is an investment manager of real estates, lands and infrastructures. Trading is one of his hobbies. He has been trying to be a quant for 5 years and is aspiring to apply for a PhD Programming in Computing Finance.

**Project**

Contrary to a more developed market, arbitrage opportunities are not readily realized which suggests there might be opportunities for those looking and able to take advantage of them. My project focuses on **China’s futures market** using Statistical Arbitrage and Pair trading techniques.

The project run Augmented Dickey-Fuller test on the spread to confirm statistically whether the series is mean reverting or not, calculate Kalman Filter regression on the spread series and a lagged version of the spread series in order to then use the coefficient to calculate the half-life of mean reversion. The results show that though has a relative lower daily Sharpe ratio (2.87 vs. 3.67), the out-sample portfolio has a higher expected daily return and that the out-sample portfolio has a relative higher CAGR (0.0858 vs. 0.07882) but also has a relatively longer average drawdown days.

**Introduction/Project Motivation**

**The project topic: Statistical Arbitrage: Pair trading in China’s Futures Markets**

Stocks cannot be shorted according to current **China’s trading rules**. Contrary to a more developed market, arbitrage opportunities are not readily realized which suggests there might be opportunities for those looking and able to take advantage of them. Therefore, I decided to focus on China’s futures market using Statistical Arbitrage and Pair trading techniques.

**The strategy idea**

The trading strategy implemented in this project is called “**Statistical Arbitrage Trading**”, also known as “**Pairs Trading**” which is a contrarian strategy designed to profit from the mean-reverting behaviour of a certain pair ratio. The assumption behind this strategy is that the spread from pairs that show properties of co-integration is mean reverting in nature and therefore will provide arbitrage opportunities if the spread deviates significantly from the mean.

**The dataset**

Data-set will come from China Financial Futures Exchange (CFFEX), Shanghai Futures Exchange (SHFE), Dalian Commodity Exchange (DCE) and Zhengzhou Commodity Exchange (ZCE). All the daily data from the above four Exchanges will be accessed through UQER’s API due to the availability of data. The trading strategy will be back-tested for 678 days (the period from 3/30/2015 to 31/12/2017). The first 542 day (the period from 3/30/2015 to 14/11/2016 accounts for 80% of total period) is the in-sample back-testing period, and the rest 136 day (the period from 15/11/2016 to 31/12/2017 accounts for 20 % of total period) is the out sample back-testing period.

**China Financial Futures Exchange** (CFFEX) is a demutualized exchange dedicated to the trading, clearing and settlement of financial futures, options and other derivatives. On September 8, 2006, with the approval of the State Council and China Securities Regulatory Commission (CSRC), CFFEX was established in Shanghai by Shanghai Futures Exchange, Zhengzhou Commodity Exchange, Dalian Commodity Exchange, Shanghai Stock Exchange and Shenzhen Stock Exchange.

**Shanghai Futures Exchange** (SHFE) is organized under relevant rules and regulations. A self-regulated entity, it performs functions that are specified in its bylaws and state laws and regulations. The **China Securities Regulatory Commission** (CSRC) regulates it. At present, futures contracts’ underlying **commodities**, i.e., gold, silver, copper, aluminium, lead, steel rebar, steel wire rod, natural rubber, fuel oil and zinc, are listed for trading.

**Dalian Commodity Exchange** (DCE) is a futures exchange approved by the State Council and regulated by China Securities Regulatory Commission (CSRC). Over the years, through an orderly operation and stable development, DCE has already become world’s **largest agricultural futures market** as well as the largest futures market for oils, plastics, coal, metallurgical coke, and iron ore. It is also an important futures trading centre in China. By the end of 2017, a total of 16 futures contracts and 1 option contract have been listed for trading on DCE, which include No.1 soybean, soybean meal, corn, No. 2 Soybean, soybean oil, linear low density polyethylene (LLDPE), RBD palm olein, polyvinyl chloride (PVC), metallurgical coke, coking coal, iron ore, egg, fiberboard, blockboard, polypropylene (PP), cornstarch futures and soybean meal option.

**Zhengzhou Commodity Exchange** (ZCE) is the first pilot futures market approved by the State Council. At present, the listed products on ZCE include: wheat (Strong Gluten Wheat and Common Wheat), Early Long Grain Non-glutinous Rice, Japonica Rice, Cotton, Rapeseed, Rapeseed Oil, Rapeseed Meal, White Sugar, Steam Coal, Methanol, Pure Terephthalic Acid (PTA) and Flat Glass, form a comprehensive range of products covering several crucial areas of the national economy include agriculture, energy, chemical industry and construction materials.

**The motivation for choosing this particular strategy domain**

My focuses on China’s future market is out of the following main reasons:

- To begin with, due to the not-shorting limitation of China’s stock markets, we only can long stocks, which makes it is impossible to do pair trading with stocks in China. Because when we do pair trading, we always long few stocks and short ones with high correlation.
- What is more, there are very few algo trading firms/strategies that are operating in China’s future exchange. I believe this should provide great opportunities, as there is little competition. Contrary to a more developed market, arbitrage opportunities aren’t readily realized which suggests there might be opportunities for those looking and able to take advantage of them.
- Last but not the least, UQER provides excellent APIs, through which I can access all daily main contract data from four future exchange of China. As we all know, high-quality data plays a crucial role in algo trading. The accessibility of data is one of the important factors We should consider when we are choosing markets and strategies.

**A brief outline of what we will do in the following chapters:**

- Define our symbol pair, download the relevant price data from UQER and make sure the data downloaded for each symbol is of the same length.
- Every possible contract pair will be tested for co-integration. An
**ADF test**will be performed such that, the alternative hypothesis is that the pair to be tested is stationary. - Run an Augmented Dickey-Fuller test on the spread to confirm statistically whether the series is mean reverting or not. We will also calculate the
**Hurst exponent**of the spread series. - Run a
**Kalman Filter**regression on the spread series and a lagged version of the spread series in order to then use the coefficient to calculate the half-life of**mean reversion**. - Calculate
**Z-scores**for trading signal, define enter and out Z-score level for back-testing.

**Data Mining**

**Access the daily main contract data from the four future exchanges.**

The daily trading prices of the main contract are accessed through UQER’s API. The first 542 day (the period from 3/30/2015 to 14/11/2016 accounts for 80% of total period) is the in sample back-testing period, and the rest 136day (the period from 15/11/2016 to 31/12/2017 accounts for 20 % of total period) is the out sample back-testing period.

Using in sample data, we find there are 5 contracts from CFFEX, 14 contracts from SHFE, 16 contracts from DCE, 18 contracts from ZCE. Delete the repeated Contracts in CFFEX, there are 48 contracts remaining.

# import all packages # import necessary libraries import numpy as np import pandas as pd import matplotlib as mpl from pykalman import KalmanFilter from datetime import datetime from numpy import log, polyfit, sqrt, std, subtract import statsmodels.tsa.stattools as ts import statsmodels.api as sm import matplotlib.pyplot as plt import seaborn as sns import ffn # define functions def load_data(): # set the working directory import os #os.getcwd() # this is to check the current working directory #os.chdir("D://EPAT//09 FP//") all_contracts = pd.read_csv('training data.csv',index_col='tradeDate',parse_dates=True) p_sorted = pd.read_csv('training_p_sorted.csv',index_col='id',parse_dates=False) return all_contracts,p_sorted

OUT:

The # of Contracts in CFFEX： 5 There are： ['TF', 'IH', 'IC', 'T', 'IF'] The # of Contracts in SHFE： 14 There are： ['NI', 'ZN', 'FU', 'AG', 'RU', 'AL', 'PB', 'BU', 'AU', 'SN', 'RB', 'HC', 'CU', 'WR'] The # of Contracts in DCE： 16 There are： ['A', 'C', 'B', 'CS', 'BB', 'PP', 'I', 'J', 'M', 'L', 'JM', 'FB', 'JD', 'V', 'Y', 'P'] The # of Contracts in ZCE： 18 There are： ['MA', 'OI', 'RS', 'SR', 'CF', 'JR', 'WH', 'AP', 'CY', 'LR', 'PM', 'SM', 'FG', 'RM', 'TC', 'RI', 'SF', 'TA'] Delete the repeated Contracts in CFFEX, the remaining： 48

**Find potential trading pairs**

Now that stocks have been filtered for their data and daily liquidity, every possible stock pair for each industry will be tested for co-integration.

Plot the heatmap of pvalue_matrix:

Using in sample data, an ADF test will be performed such that, the alternative hypothesis is that the pair to be tested is stationary. The **null hypothesis** will be rejected for p-values < 0.05. There are 23 pairs with p-values less than 0.05.

def find_cointegrated_pairs(dataframe, critial_level = 0.05): n = dataframe.shape[1] # the length of dateframe pvalue_matrix = np.ones((n, n)) # initialize the matrix of p keys = dataframe.keys() # get the column names pairs = [] # initilize the list for cointegration for i in range(n): for j in range(i+1, n): # for j bigger than i stock1 = dataframe[keys[i]] # obtain the price of two contract stock2 = dataframe[keys[j]] result = sm.tsa.stattools.coint(stock1, stock2) # get conintegration pvalue = result[1] # get the pvalue pvalue_matrix[i, j] = pvalue if pvalue < critial_level: # if p-value less than the critical level pairs.append((keys[i], keys[j], pvalue)) # record the contract with that p-value return pvalue_matrix, pairs pvalue_matrix, pairs = find_cointegrated_pairs(data); print(pairs)

OUT:

S1 S2 Pvalue 20 TA I 0.003710 5 CF TC 0.007014 2 SR J 0.008478 6 L RU 0.010882 21 TA J 0.015553 12 ZN RB 0.018324 14 SN RB 0.018869 19 RU I 0.019091 0 JM SR 0.020848 9 L TA 0.021215 3 HC SN 0.022591 7 L V 0.026507 11 M AG 0.027911 13 RM AG 0.033350 18 RU TA 0.036407 8 L MA 0.042057 16 TC FG 0.042588 1 OI V 0.043445 22 TA SF 0.044489 4 HC TC 0.046238 10 L I 0.046778 17 RU MA 0.048415 15 SN J 0.049904

**Data Analysis**

**Trading logic**

- Calculate the spread of each pair (Spread = Y – hedge ratio * X )
- Using Kalman Filter Regression Function to calculate hedge ratio
- Calculate z-score of ‘s’, using rolling mean and standard deviation for the time period of ‘half-life’ intervals. Save this as z-score
- Using half-life function to calculate the half-life
- Define upper entry Z-score = 2.0, lower entry Z-score = 2.0, exit Z-score = 0.0
- When Z-score crosses upper entry Z-score, go SHORT; close the position with Z-score return exit Z-score
- When Z-score crosses lower entry Z-score, go LONG; close the position with Z-score return exit Z-score
- Back-test each pair, and calculate the performance statistics, each as max drowns down Sharpe ratio
- Build up portfolios with equal market value distribution, each pair has the same market value

**Kalman Filter**

According to Wikipedia, Kalman filtering, also known as **linear quadratic estimation** (LQE), is an algorithm that uses a series of measurements observed over time, containing statistical noise and other inaccuracies, and produces estimates of unknown variables that tend to be more accurate than those based on a single measurement alone, by estimating a joint probability distribution over the variables for each time-frame. The filter is named after Rudolf E. Kálmán, one of the primary developers of its theory.

Because the Kalman filter updates its estimates at every time step and tends to weigh recent observations more than older ones, a particularly useful application is an estimation of rolling parameters of the data. When using a Kalman filter, there’s no window length that we need to specify. This is useful for computing the moving average if that’s what we are interested in, or for smoothing out estimates of other quantities. Thanks to Quantopian, they already provide the source code for calculating the moving average and Regression with Kalman Filter.

def KalmanFilterAverage(x): # Construct a Kalman filter from pykalman import KalmanFilter kf = KalmanFilter(transition_matrices = [1], observation_matrices = [1], initial_state_mean = 0, initial_state_covariance = 1, observation_covariance=1, transition_covariance=.01) # Use the observed values of the price to get a rolling mean state_means, _ = kf.filter(x.values) state_means = pd.Series(state_means.flatten(), index=x.index) return state_means # Kalman filter regression def KalmanFilterRegression(x,y): delta = 1e-3 trans_cov = delta / (1 - delta) * np.eye(2) # How much random walk wiggles obs_mat = np.expand_dims(np.vstack([[x], [np.ones(len(x))]]).T, axis=1) kf = KalmanFilter(n_dim_obs=1, n_dim_state=2, # y is 1-dimensional, (alpha, beta) is 2-dimensional initial_state_mean=[0,0], initial_state_covariance=np.ones((2, 2)), transition_matrices=np.eye(2), observation_matrices=obs_mat, observation_covariance=2, transition_covariance=trans_cov) # Use the observations y to get running estimates and errors for the state parameters state_means, state_covs = kf.filter(y.values) return state_means

**Hurst exponent and Half-life**

The Hurst exponent is used as a measure of long-term memory of time series. It relates to the auto-correlations of the time series and the rate at which these decrease as the lag between pairs of values increases. Studies involving the Hurst exponent were originally developed in hydrology for the practical matter of determining optimum dam sizing for the Nile river’s volatile rain and drought conditions that had been observed over a long period of time. The name “Hurst exponent”, or “Hurst coefficient”, derives from Harold Edwin Hurst (1880–1978), who was the lead researcher in these studies; the use of the standard notation H for the coefficient relates to his name also.

To simplify things, the important info to remember here is that a time series can be characterized in the following manner with regard to the Hurst exponent (H):

- H < 0.5 – The time series is mean reverting
- H = 0.5 – The time series is a Geometric Brownian Motion
- H > 0.5 – The time series is trending

However just because a time series displays mean-reverting properties, it doesn’t necessarily mean that we can trade it profitably – there’s a difference between a series that deviates and mean reverts every week and one that takes 10 years to mean revert. I’m not sure too many traders would be willing to sit and wait around for 10 years to close out a trade profitably.

To get an idea of how long each mean reversion is going to take, we can look into the “half-life” of the time series.

def half_life(spread): spread_lag = spread.shift(1) spread_lag.iloc[0] = spread_lag.iloc[1] spread_ret = spread - spread_lag spread_ret.iloc[0] = spread_ret.iloc[1] spread_lag2 = sm.add_constant(spread_lag) model = sm.OLS(spread_ret,spread_lag2) res = model.fit() halflife = int(round(-np.log(2) / res.params[1],0)) if halflife <= 0: halflife = 1 return halflife

**Back-test Engine**

The back-test engine follows the steps:

- Calculate Spread = Y – hedge ratio * X
- Using Kalman Filter Regression Function to calculate hedge ratio
- Calculate z-score of ‘s’, using rolling mean and standard deviation for the time period of ‘half-life’ intervals. Save this as z-score
- Using half-life Function to calculate half life
- Define upper entry Z-score = 2.0, lower entry Z-score = 2.0, exit Z-score = 0.0
- When Z-score crosses upper entry Z-score, go SHORT; close the position with Z-score return exit Z-score
- When Z-score crosses lower entry Z-score, go LONG; close the position with Z-score return exit Z-score

def backtest(s1, s2, x, y ): ############################################################# # INPUT: # s1: the symbol of contract one # s2: the symbol of contract two # x: the price series of contract one # y: the price series of contract two # OUTPUT: # df1['cum rets']: cumulative returns in pandas data frame # sharpe: sharpe ratio # CAGR: CAGR # run regression to find hedge ratio and then create spread series df1 = pd.DataFrame({'y':y,'x':x}) state_means = KalmanFilterRegression(KalmanFilterAverage(x),KalmanFilterAverage(y)) df1['hr'] = - state_means[:,0] df1['spread'] = df1.y + (df1.x * df1.hr) # calculate half life halflife = half_life(df1['spread']) # calculate z-score with window = half life period meanSpread = df1.spread.rolling(window=halflife).mean() stdSpread = df1.spread.rolling(window=halflife).std() df1['zScore'] = (df1.spread-meanSpread)/stdSpread ############################################################## # trading logic entryZscore = 2 exitZscore = 0 #set up num units long df1['long entry'] = ((df1.zScore < - entryZscore) & ( df1.zScore.shift(1) > - entryZscore)) df1['long exit'] = ((df1.zScore > - exitZscore) & (df1.zScore.shift(1) < - exitZscore)) df1['num units long'] = np.nan df1.loc[df1['long entry'],'num units long'] = 1 df1.loc[df1['long exit'],'num units long'] = 0 df1['num units long'][0] = 0 df1['num units long'] = df1['num units long'].fillna(method='pad') #set up num units short df1['short entry'] = ((df1.zScore > entryZscore) & ( df1.zScore.shift(1) < entryZscore)) df1['short exit'] = ((df1.zScore < exitZscore) & (df1.zScore.shift(1) > exitZscore)) df1.loc[df1['short entry'],'num units short'] = -1 df1.loc[df1['short exit'],'num units short'] = 0 df1['num units short'][0] = 0 df1['num units short'] = df1['num units short'].fillna(method='pad') df1['numUnits'] = df1['num units long'] + df1['num units short'] df1['spread pct ch'] = (df1['spread'] - df1['spread'].shift(1)) / ((df1['x'] * abs(df1['hr'])) + df1['y']) df1['port rets'] = df1['spread pct ch'] * df1['numUnits'].shift(1) df1['cum rets'] = df1['port rets'].cumsum() df1['cum rets'] = df1['cum rets'] + 1 name = "bt"+ s1 + "-" + s2 + ".csv" df1.to_csv(name) ############################################################## try: sharpe = ((df1['port rets'].mean() / df1['port rets'].std()) * sqrt(252)) except ZeroDivisionError: sharpe = 0.0 ############################################################## start_val = 1 end_val = df1['cum rets'].iat[-1] start_date = df1.iloc[0].name end_date = df1.iloc[-1].name days = (end_date - start_date).days CAGR = round(((float(end_val) / float(start_val)) ** (252.0/days)) - 1,4) return df1['cum rets'], sharpe, CAGR

**In-sample backtesting results**

The in-sample backtesting period is from 2015/2/27 to 2017/6/15.

**(1) In-sample backtesting of each pair**

**Performance statistics**

There are 14 pairs passed further ADF test, the performance statistics are shown in the following table.

As one can see, results vary considerably between pairs. Maximum drawdown ranges from a low of 1.09% to a high of 10.45%. CAGR ranges from 4.22% to 12.75%. Total return ranges from 9.61% to 31.93%.

**Accumulated returns for each trading pair**

**The drawn-down plot of each pair**

**(2) In-sample backtesting of portfolio**

Portfolio: the fund is equally distributed among the above 14 contracts. The market value of each contract is 1/14 of the total amount of cash.

**Performance statistics**

As we can see from the above table, the total return on the portfolio is 18%, the daily Sharpe ratio is 3.67. The maximum drown down is 1.6%, the average drawn down days is 5.5.

**Accumulated returns for the portfolio**

**The drawn-down****plot of the portfolio**

**Out Sample backtesting results**

The out sample backtesting period is from 2017/6/16 to 2017/12/31.

**(1) Out sample backtesting of each pair**

**Accumulated returns for each trading pair**

**Accumulated returns for the portfolio**

**Performance statistics of the portfolio**

As we can see from the above table, the total return on the portfolio is 4.5%, the daily Sharpe ratio is 2.87. The maximum drown down is 0.9%, the average drawn down days is 9.69.

**The drawn down****the plot of the portfolio**

**4 Key Findings**

- Although the out-sample portfolio has a relative lower daily Sharpe ratio (2.87 vs. 3.67), the out-sample portfolio has a higher expected daily return (0.0829 vs. 0.0787)
- The out-sample portfolio has a relatively longer average drawdown day (9.69 vs. 5.54)
- The out-sample portfolio has a relative higher CAGR (0.0858 vs. 0.07882)

**Challenges and Limitations**

- Further research can test the in sample performance with different entry and exit z-score pairs, through numbers of simulation with different entry and exit z-score pairs to find the optimize z-score pairs
- This research report is based on daily trading data; the same back-testing engine can be used to analyze the minute data, hour data and half data
- The back-testing algorithm does not take slippage and trading fees into consideration
- Further research can explore other filters instead of just Kalman filter
- Another window to optimize is the length of the training period and how frequently the Kalman filter has to be recalibrated
- The back-testing is based on main contracts data, in real trading, the main contracts should be projected to the special contracts in each month

**Conclusion**

Contrary to a more developed market, arbitrage opportunities are not readily realized which suggests there might be opportunities for those looking and able to take advantage of them. My project focuses on China’s futures market using **Statistical Arbitrage** and Pair trading techniques. The project run **Augmented Dickey-Fuller test** on the spread to confirm statistically whether the series is mean reverting or not, calculate Kalman Filter regression on the spread series and a lagged version of the spread series in order to then use the coefficient to calculate the half-life of mean reversion.

The results show that though has a relative lower daily **Sharpe ratio** (2.87 vs. 3.67), the out-sample portfolio has a higher expected daily return and that the out-sample portfolio has a relative higher CAGR (0.0858 vs. 0.07882) but also has a relatively longer average drawdown days. The back-testing algorithm can be used to analyze the minute data, hour data. The main limitation is that the backtest has not taken slippage and trading fees into consideration.

**Next Step**

If you want to learn various aspects of Algorithmic trading then check out the Executive Programme in Algorithmic Trading (EPAT™). The course covers training modules like Statistics & Econometrics, Financial Computing & Technology, and Algorithmic & Quantitative Trading. EPAT™ equips you with the required skill sets to build a promising career in algorithmic trading. Enroll now!

*Disclaimer: The information in this project is true and complete to the best of our Student’s knowledge. All recommendations are made without guarantee on the part of the student or QuantInsti®. The student and QuantInsti® disclaim any liability in connection with the use of this information. All content provided in this project is for informational purposes only and we do not guarantee that by using the guidance you will derive a certain profit.*