Suggestion on the relation between Cointegration and Correlation

Suggestion on the relation between Cointegration and Correlation

We like to see high correlation and high cointegration.

Remember, correlation measures how much the two securities move in the same direction at the same time.  Since we are trading a reversion of their price ratio to the mean at a moment when they are "out-of-whack", we actually need the spread between them to converge, not just move in the same direction. So while correlation tells us a lot about how similar two securities return profiles have been, it doesn't necessarily mean the spread will converge.

Enter cointegration.

We like to see correlation >60%.  However, if Cointegration is very strong, we believe a lower correlation can be tolerated for the reasons above.

We call a pair cointegrated when Cointegration (as measured by PTF) is showing 0.90 or higher.  That equates to a p-value of 0.10 or less in the ADF test.  Some traders would only call 0.95 or higher Cointegrated.  Up to you.

At the end of the day, what Geoff - our Managing Director - think makes the strongest case for trading a pair is that:

1. It is FUNDAMENTALLY correlated - that means the two stocks are in a very similar line of business and logically should react to economic developments in a very similar fashion.  Use the Fundamentals Snapshot in PTF PRO to easily review the necessary parameters and make your judgment;

2. It has a long backtest history of at least 8 or 9 trades that are showing a great return profile.

But that's us!  You may take a different view.

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