Cointegrated forex pairs hedging

If they do not form a trend, that means the spread moves around 0 randomly and is stationary. The Dickey Fuller test is a hypothesis test which gives a p-value as the result. If this value is less than 0. So far, we have discussed the challenges and statistics involved in selecting a pair of stocks for statistical arbitrage.

By using the cointegration tests, we can say within a certain level of a confidence interval that the spread between the two stocks is a stationary signal. In other words, this signal is mean-reverting. Having already established that the equation above is mean reverting, we now need to identify the extreme points or threshold levels that when crossed by this signal, trigger trading orders for pairs trading. To be able to identify these threshold levels, a statistical construct called z-score is widely used in pairs trading.

Define threshold as anything between 1. This parameter will change as per the backtesting results without risking overfitting data. We have now understood entry points in pairs trading. Now we will move on to the other end, exit points. Defining Exit points Stop loss Stop loss is defined for scenarios when the expected outcome does not occur. For instance, if we chose entry signals at 2-sigma, we are expecting that the spread will revert back to the mean from this threshold.

However, it is possible that the spread continues to blow up. Say it reaches 2. To prevent further losses, you place stop loss at say 3-sigma. In addition to placing a predefined stop-loss criterion such as 3-sigma or extreme variation from the mean, you can check on the cointegration value.

If the cointegration is broken while the pair is ON, the strategy warrants cutting the positions since the basic hypothesis is nullified. Take profit It is defined as scenarios where you take profit before the prices move in the other direction. For instance, say you are LONG on the spread, that is, you have bought stock A and sold stock B as per the definition of spread in the article.

The expectation is that spread will revert back to the mean or 0. In a profitable situation, the mean would be approaching zero or very close to it. You can keep the take profit scenario as when the mean crosses zero for the first time after reverting from the threshold levels. There can be many ways of defining take profits depending on your risk appetite and backtesting results.

What often works is your experience and a broad range of potent skill sets that allow you to grasp a hold of the complete scenario before jumping to conclusions. As we mentioned, your appetite for risk and backtesting results will work for you.

Automation and practical applications are the keys here. Let us take a recap of what we have understood so far. Pairs Trading can be called a mean reversion strategy where we bet that the prices will revert to their historical trends. For performing the pairs trading strategy, we have the following: Assumptions For simplification purposes, we ignore bid-ask spreads.

Prices are available at 5 minutes intervals and we trade at the 5-minute closing price only. Since this is discrete data, squaring off of the position happens at the end of the candle i. Only the regular session T is traded. Input parameters Please note that all the values for the input parameters are configurable.

An average of 10 candles one candle is equal to every 5-minute price is considered. It also helps in the mitigation of risks as the pairs strategy involves dealing with two securities so if one is underperforming then there are chances that the other absorbs the losses. Good returns Pairs trading strategy helps the trader to get good returns regardless of the conditions of the market.

Hedging The best advantage of pairs trading is that the trader is completely hedged. Hedging is done in this strategy as the trader sells the overvalued security and purchases the undervalued security, thereby, limiting the chances of loss.

Disadvantages of pairs trading The disadvantages of pairs trading are: Reliance of the High Statistical Correlation Pairs trading relies on the securities having a high statistical correlation. Most of the traders require a correlation of at least 0. High Commission Some traders highly discourage pairs trading because of its higher commission charges. Sometimes even a single Pair trade requires a Pair trader to pay a commission which is nearly double the amount of the commission required in the standard trade.

Price Filling The generation of profits in pairs trading involves relying on margins that are too less. The transactions are made in large quantities which shows the risk of filling the stock orders at the desired price when positions are open in a pair trading is high. Even a small difference in the purchase price or sale price of the security can prove significant as the volume of transactions is high.

Conclusion Pairs trading is a trading strategy that is based on the assumption that the highly correlated securities will come back to their neutral position after any divergence. This strategy can be incorporated into any kind of trading and in any market such as stocks, forex etc. Quantitative investment and trading ideas, research, and analysis. Friday, June 17, When cointegration of a pair breaks down I have written a lot in the past about the cointegration of ETF pairs, and how this condition can lead to profitable pairs trading.

However, as every investment advisor could have told you, past cointegration is no guarantee of future cointegration. Often, cointegration for a pair breaks down for an extended period, maybe as long as a half a year or more.

Naturally, trading this pair during this period is a losing proposition, but abandoning such a pair completely is also unsatisfactory, since cointegration often mysteriously returns after a while. When I first tested it in , it was an excellent candidate for pair trading, and I not only traded it in my personal portfolio, but we traded it in our fund too.

Unfortunately, it went haywire in We promptly abandoned it, only to see the strategy recovered sharply in So the big question is: how do we know whether the loss of cointegration is temporary, and how do we know when to resume trading a pair? To answer the first question, it is often necessary to go beyond the technicals, and delve into the fundamentals of pair.

When I taught my pairs trading workshop in South Africa, several portfolio managers in attendance told me that there are 2 reasons why gold spot price diverged from gold miners' stock prices.

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