Hands-On Machine Learning for Algorithmic Trading

Testing for cointegration

There are two major approaches to testing for cointegration:

• The Engle–Granger two-step method
• The Johansen procedure

The Engle–Granger method involves regressing one series on another, and then applying an ADF unit-root test to the regression residual. If the null hypothesis can be rejected so that we assume the residuals are stationary, then the series are co-integrated. A key benefit of this approach is that the regression coefficient represents the multiplier that renders the combination stationary, that is, mean-reverting. We will return to this aspect when leveraging cointegration for a pairs-trading strategy. On the other hand, this approach is limited to identifying cointegration for pairs of series as ...