1-15. Pairs Trading and Mean Reversion

Now that you’ve reached the end of this lesson, we hope you’ve gained a better understanding of pairs trading and mean reversion in general. Remember that mean reversion trading follows these general steps. Find a pair of assets or a pair of portfolios that have some economic link, compute the hedge ratio, use the hedge … Read more

It’s also important to decide how we define when two stocks are diverging from there spread. For this, we want to choose a threshold. If the spread exceeds the threshold, then we can assume that the spread is temporary and will revert back to its historical mean. We can have two kinds of thresholds. One … Read more

Let’s see how we would find cointegrated pairs from a universe of stocks. For example, we might look at companies listed in the S&P 500. If we were to compare every pair of stocks this would take a long time. More importantly, we would end up with spurious false positives just by chance. It’s important … Read more

Let’s add more detail to describe the relationship between a pair of stocks. Recall that some time series such as stock prices are integrated of order one. By this, I mean that if we take the time difference of this time series, we can get a stationary series. When a series is stationary, it is … Read more

To find good pairs to trade, we want to find pairs of companies that have economic links. It’s common to find stocks that are in the same sector and country. It’s also good to look for a less obvious but still meaningful connections. For instance, companies that trade internationally maybe affected by trade decisions by … Read more

Let’s take a closer look at pairs trade. When two companies have economic links, this implies that their stock prices may also move in a similar manner. For example, company A sells frozen green peas, and company B cells frozen carrots. Since frozen peas and carrots are often combined and sold together, we can see … Read more

Let’s look at mean reversion in detail. We can plot a stock’s price movements against its moving average. We tend to see that when the price increases or decreases significantly from this moving average, the price then reverts back towards this moving average. To describe a mean reverting process with some math, we’ll use what’s … Read more

In this lesson, we’ll learn about two properties of financial assets, mean reversion, and co-integration. Based on these properties, we will learn about the trading strategy called, Paris trading. From there, we will examine the more general strategy called, mean reversion trading. First, let’s preview some concepts. What is mean reversion? A mean reverting time … Read more