The key factor when comparing the two legs would be statistical fitness. In addition to a high degree of positive statisitical relationship between spread legs, traditional spread traders also usually demand a high degree of positive fundamental relationship between the legs. An example would be a US Treasury Bill versus a similar duration Eurodollar future, Nymex Heating Oil versus Nymex Crude Oil, or equity shares within the same market sector and with similar market caps: IBM vs HPQ or WMT vs TGT would be an example. Stat Arb traders are typically concerned primarily with the statistical relationship between spread leg combinations - remember, the idea is to capture arbitrage differences between highly correlated instruments and insulate yourself from broad market delta directionality in the process. One example is HOG vs. ENS: Harley Davidson (motorcycles) versus Enersys (industrial lighting); both have a positive correlation of 95.7% over the past two years daily close-on close. Obviously, both companies have next to nothing in common otherwise. The quants are updating their databases every day before the open.
Did you know that the Canadian Dollar and the WTI Crude Oil contract have a 94.6 % positive correlation ?
Thinking out loud ... This accomplishes the first step of qualifying the pair. You have two logically related markets (commodity/supplier market) whose price series are highly correlated. Based on your charts, you selected an intraday timeframe (a decision you did not comment on, but is implicit in your correlation test using this timeframe). You did not indicate the results of a cointegration test, but that test may be more appropriate for trading the convergence of the spread (mean reversion). If your approach is to trade the divergence of the spread (trend), then correlation of two related markets may be sufficient to qualify them as spread candidates. The next (more challenging) step is modelling the spread (or the component legs) to time the trade entry.
And that I do better than anyone else in the business so I have been told - and that methodology is strictly proprietary for me and my clients. My apologies in advance.
Bone, thanks as always for your posts on spread trading. Also grateful to ET sponsors like yourself who pay the bills around here. Across the hundreds (thousands?) of ET members, I'm hoping we hear from other spread traders, as well. My apologies to the OP for butting in on his thread, but I'm trying to frame questions/focus to keep the discussion going on this interesting topic.
And my thanks to you for butting in on the OP and exhibiting some real knowledge on the topic. So exhausting to argue with retail punters and SIM rangers who are experts on all topics trading. I am astonished and quite pleased that the discourse has been academic up to this point.
If you stay in this business long enough, you come to the realization that trading as a profession attracts alot of very smart people - and that your perceptions about what works and what does not work is, in fact, really quite limited and in fact is generally ego-centric.
Bam ! I have four diagonals turned sideways for my execution workstation - and they are still tiled into the corners like a giant hand of cards. The modeling workstation screens tan my good side. I have a box of screen wipes to keep all of them clean. Quite a task.
You will notice that an inordinately large percentage of equity-oriented Hedge Funds innocuously list their strategy as 'relative value'. Why ? Because any institutional investor submitting themselves to at the very least a "2 and 20" haircut demands serious alpha returns - that is the only reason to invest in a HF. You are paying a premium for the Manager's expertise and ability to generate gains independent of the broad market's price action. If you talk to the Bloomberg Sales Manager in Manhattan, or an Account Manager with some serious professional clients at NewEdge or Man Financial, you come to the rapid conclusion that the only brave souls taking directional risk these days seem to be the SIM rangers at C2 or the spec retail scalpers clearing IB. A Relative Value Portfolio Manager is, in essence, a spread trader whether he cares to admit it or not. Below I am attaching two charts for comparison's sake - SPY and then a highly tweaked basket of seven equity stock names versus SPY. Point being, Stevie Wonder could see which market is easier to trade. With that kind of smooth and predictable price action, you should have the confidence to lever the piss out of it. By definition, a properly modelled spread trade will always be easier to trade, cheaper to capitalize, and exhibit more modest drawdown characteristics than any flat price directional analog. And I can prove it time and time again. You build you own markets. And you engineer out the noise and the chop and the bad harmonics. ENJOY !