Basics about Cointegration (pairs trading)

Discussion in 'Strategy Development' started by emilsson, Mar 22, 2013.

  1. emilsson


    Hello friends, this is my first post here. Been lurking a while, but now I have question as I get more and more interested, I hope someone can help me, would be much appreciated!

    fact A) When I trade a pair, I choose to use dollar neutral strategy. That is, I spend equal amount of money on short and long side in the pair. This means I buy X amount of stock1, and short Y amount of stock2, where X != Y.

    fact B) I have also identified some cointegrated pairs. When I calculate the adf test I also get a hedge ratio, so I can form the spread which is likely to be mean reverting:
    Spread = s1 - hedgeratio * s2
    This means I should buy One s1 stock, and short hedgeratio*s2 stock.

    My question is, how are X and Y and One and hedgeratio related to each other?

    Apparently, I should short Y amount of s2 stock because A) says so. But B) says I should short hedgeratio amount of s2 stock. So, could this be the answer, maybe?:

    amount of s1 stock to long: X
    amount of s2 stock to short: Y * hedgeratio

    Another question, I look for a trade signal, typically it is s1/s2 and then I check the std dev. But I trade the Spread.
    So the trade signal has a weight of one s1 divided by one s2. But I trade this: buy one s1 and sell hedgeratio*s2. This means my trade signal will be on something, but I will trade on something else!!! That is weird? Can I really do like this?

    The trade signal should be modified to s1/(hedgeratio*s2) or? Can anyone shed some light on this? Would be much appreciated!