Analyzing the profit potential of Pair Trading strategies in the foreign exchange market through Cointegration Test

Abstract

This study aims to analyze the profit potential of Pair Trading strategies in the foreign exchange market through cointegration test. The trading signals are based on Z-scores in both positive and negative zones, considering currency pairs with and without cointegration test. The performance of each trading strategy are compared. Additionally, the original strategies are improved to reduce Maximum Drawdown by implementing enhanced money management techniques (MM). The data used for this study consists of daily closing price time series of each currency pair, including EUR/USD, GBP/USD, AUD/USD, NZD/USD. The data was collected from the MT5 broker Pepperstone, covering the period from January 1, 2018, to December 31, 2022, totaling 5 years.

The results of the study indicate that the strategy that trades only on currency pairs with cointegration testing yields the highest returns. Specifically, the strategies that performed the best in terms of returns were the Cointegration Testing strategy and the Cointegration Testing strategy with MM techniques implemented. However, when comparing the Maximum Drawdown, it is found that the Cointegration Testing strategy with MM had significantly lower values than to compare with other strategies. This indicates that the maximum drawdown can be reduced by considering MM included.