Using Correlation in Pair Trading

The concept of correlation of financial instruments is common to many traders. But at the same time, few of them fully understand the possibility of this powerful statistical analysis tool and represent how it applies to practice. Meanwhile, correlation is an indispensable tool for successful trading on a pair trading strategy. Consider why.

So what is the correlation of financial instruments? Correlation is a quantity that reflects the level of graphic similarity of the two instruments. Actually, the introduction of correlation is an attempt to express the level of similarity of the graph with just one value, called the correlation coefficient. The value of this coefficient varies from -1 to 1. Where 1 denotes the maximum level of equality, when growth on one graph is always accompanied by the same increase in strength on the other side, 0 is the absence of similarity, and -1 is reverse resemblance, when growth at one accompanied by a proportional decrease in the second. Using Correlation in Pair Trading

Since the correlation, in fact, reflects only the degree of graphic similarity, it is absolutely not necessary that in the presence of a high correlation coefficient, there will be some real interconnections between trading instruments. It is likely that two graphs for random reasons are exactly the same to each other. But if the number of points of the graph is large enough, ie the correlation is statistically reliable, then the chance of chance happens to be meaningless. In this case, we can talk about the relationship between financial instruments, which guarantees the similarity of their schedule.

This is the correlation ability to measure the interrelationship between financial instruments so it becomes a very useful tool for pair trading. Remember what is pair trading. This is an interdependent multidirectional trading tool, where advantages are extracted by playing to eliminate the imbalances that appear periodically between these tools. The key word here is “interconnected,” because the success of the strategy will depend directly on how strong and real the relationship between a pair of instruments is. But how to find interconnected tools among the hundreds of options available on different exchanges? And here the correlation coefficients come to save him. Suffice it to divide all possible pairwise combinations of trading instruments, calculate the correlation coefficients for them and select which indicator will be a fairly high indicator (eg more than 0.8). Using Correlation in Pair Trading

In order not to do such complex calculations yourself, you can use online services to calculate the correlation. One of the most convenient free services is the Correlation of pair on the megatrader.org site. This service displays pairwise correlation tools in the form of correlation tables, allowing you to specify a list of tools and time frames. He is also interested in the fact that, in addition to the correlation itself, it is possible to quickly calculate the weight coefficients for the instruments that make up the pair, and also to plan the spreading of the pair. To do this, just click the correlation value in the table, and the page with the spreadsheet and the calculated weights will automatically open on the site. By the way, these coefficients can be adjusted manually and see how this will affect the deployment schedule.

Of course, among selected couples with high correlation there will likely be some percentage of couples with false dependence. There are two ways to overcome this. First, during the selection, it is necessary to pay attention to the fact that both instruments come from the same economic sector. In this case, the chance of chance happens to decrease significantly. Second, it is valuable to trade not with one partner, but with a partner portfolio. Then, even if some pairs change to random, their losses will be compensated with other pairs, and the total portfolio return will remain positive.