Mean reversion without profit?

ArbMaker 4.0 was released yesterday. The software remains unique in the marketplace and questions we have had over time demonstrate a demand for detailed information specific to pairs trading using cointegration.

So, in a series of blog postings, we are increasing knowledge-sharing based on a collection of those questions.

Today’s post covers one of the more important questions: how is it that a spread trade can end up reverting to its mean at a loss? There are several ways. For example:

• The spread distribution underlying the Z score chart is not near-normal. Z scores rely on normality or near normality to be meaningful.

• The live beta deviates during the trade from the modelled historic beta. That may be due to a disturbance to the underlying cointegrated relationship – i.e. conditions are changing. This is common in FX where there are macroeconomic announcements nearly every day that are more signal than noise and can break cointegrated pairs – especially at the intraday level.

• The beta is unreliable due to a low R² (R² being a measure of model strength). We find R²s less than 70% have a higher likelihood of failing to revert with profit.

Keep in mind, too, that the Z score is a description of the spread and not an indicator of cointegration. If it blows out it may be reflecting a weakening cointegration situation; or it might be reflecting a small window size (if one was used for the Z calculation) making it more sensitive to the incoming price data.

This is one of the main reasons the software integrates “dynamic filters” into its Tracker allowing stops to be set based on MRC, R², degree of cointegration and so forth. These are measures of and/or prerequisites for cointegration and will pick up direct changes to the underlying relationship better than a stop on the Z alone.

Take our latest version 4.0 for a free trial now to test and integrate these controls into your own strategies.