Co-integration and pairs trading

Oh yeah, and you'll find Dickey-fuller test in R, of course.

Recorded Webinars by Application

Register and watch the Algorithmic Trading with MATLAB for Financial Applications webinar.

There is an example of pairs trading... very impressive indeed.

P.S. Courtesy of 52aces

msardelich,

I would have to agree with MrGecko, the MATLAB webinar is superb and there is code support on the MATLAB central website.

You can use the Dickey-Fuller or ADF test for cointegration if you're sure you have an exact method to linearly combine the two series. The DF/ADF test is primarily used to test for a unit root in one series. Much better to use the Engle-Granger 2-step or Engle & Yoo 3 step approach. You could use Johannsen, but it would be overkill seeing as you're only comparing two series at any one time.

Best of Luck.

I'm implementing co-integration with Matlab on all of the stock time-series, contact me if you are interested, safe.fore@gmail.com

Here is a good guide to pairs trading and co-integration issues (has the math but is readable if you are not mathematician):

Pairs Trading, Convergence Trading, Cointegration

You could just write your own solution to in C++/C#/Java too. The DF measure is useful but there are cruder methods which may be easier to implement. For example remembering that two co-integrated time series can be combined into a linear combination with constant SD and Mean. You could just create your optimal linear combination using linear regression then divide your data into say five samples and compare the SD and Mean for consistency. In other words we are looking for a small SD(SD) and SD(Mean). Crude but easy to program.

I wanted to share with everyone a Stock Pairs trading system that has been successful for me for the last 3 years, in both up and down stock markets.

Check it out at: http://stockpairs.collective2.com
and commentary on it at:
http://seekingalpha.com/author/rajeev-seth/instablog


This trading system screens for matched stock pairs to go long and short by doing a daily proprietary quantitative analysis of all stocks in the S&P500 Index

It may find a new entry trading signal consisting of two legs: a buy stock order and a simultaneous sell short stock order on a matching stock in the S&P 500. This computer screening generates an average of one or two paired trades per week. This gives you plenty of time to manually implement the two stock transactions in your brokerage, buying one stock and selling short the other when opening a new pair; or selling one stock and buying back a shorted stock when closing an open pair.

Our trading signal consists of simple instructions of the kind:

Buy 1000 shares of EQR, while
SIMULTANEOUSLY selling short 575 shares of VTR

You need to implement this trading signal by buying and selling both legs of the matched stock pair. You may execute the paired trading signal within a few hours of the system issuing the signal. It is very important to implement the two stock trades together, preferably on the same day, so as to derive the full benefit of the arbitrage potential in the stock pairing.

We will also provide you the closing signal on the trade pair, usually within a few weeks. Again, you must get out of the two legs together when your receive our exit signal.

Since there is plenty of time to implement the two trades, you can go about your business or hobbies without being glued to the financial markets. All you need to be able to do short selling is to open a margin account with your discount stock brokerage.

Use the trading signals given directly, instead of needing to construct a system yourself

@beatindex,

What happened to your signal? Crash and burn?