Hands-On Machine Learning for Algorithmic Trading

How to use cointegration for a pairs-trading strategy

Pairs-trading relies on a stationary, mean-reverting relationship between two asset prices. In other words, the ratio or difference between the two prices, also called the spread, may over time diverge but should ultimately return to the same level. Given such a pair, the strategy consists of going long (that is, purchasing) the under-performing asset because it would require a period of outperformance to close the gap. At the same time, one would short the asset that has moved away from the price anchor in the positive direction to fund the purchase.

cointegration represents precisely this type of stable relationship between two price series anchored by a common mean. Assuming cointegration ...