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Mean Reversion

I'm interested in Indices pairs trading, i.e. Long one index, short the other. There needs to be a very close correlation, so that in essence you are betting on relative strength, as opposed to a directional call. This is much less risky, since the two sides are hedged, and the trade is much more relaxed.
Before Russia invaded Ukraine, the Dax and Cac worked like a charm, but now volatility has gone through the roof, so that's now too risky.
Does anyone have any ideas? I'd be most grateful for any feedback, please? Thanks!

Robin Johnstone from the U.K.

Best Answer


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    I looked up Mean Reversion and Pairs Trading since I was not familiar with them. I have a few comments.

    I noticed you mention index pairs trading. Pairs trading is best suited for securities within the same sector and preferably within the same Industry Group and sub-group. Indexes tend to measure different markets.

    I believe you have to watch for a breakdown in the correlation between the pair to consider an entry. I see that divergence in the price ratio between the two holds better signals.

    You mention volatility. High periods of volatility are followed by low periods of volatility. See if this is the case historically in the market you are looking at.

    Here is a link to a scan regarding mean reversion:

    Here are the two definitions from Google:

    Mean Reversion = a theory that suggests prices and returns eventually return to their average. The strategy involves the purchase or sale of stock that recently greatly differs from its historical average. New information may become available that permanently affects the long-term valuation. Mean reversion should demonstrate a form of symmetry.

    Pair Trading = a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways. When correlation temporarily weakens - one moves up, the other down - short the outperforming stock and long the underperforming one. The bet is that the spread will eventually converge. The divergence within the pair could be caused by temporary supply/demand changes, or large buy/sell orders. There is a scarcity of opportunities. Requires exceptional risk management. This creates a hedge. Profit through simple and low risk positions. The pairs trade is market-neutral. Use price ratio for signals. Look for divergence. Inexpensive to put on because of the revenue from the short position. Position size should be matched by dollar value so that a 5% move in one equals a 5% move in the other.

    Market-Neutral = the direction of the overall market does not affect the trade's win or loss.
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    Many thanks, Kevo,
    The link was informative. The Dax and Cac mirror each other to an amazing extent and had an uncannily high success rate, better than anything I had traded previously. The underlying stocks bore similarities, be they German or French.. The longest winning run had been 34 and the longest losing run 4! However, that all changed after Russia's unwelcome meddling with Ukraine, which ain't going away any time soon.
    Thus, I need something that is immune to this carry on, which is why I'm looking furthur afield, like on your side of the pond.
    How about the Dow Industrials and Dow Transports, for example? How can I view the historical correlation between these two Indices? Can I bring up a chart showing the two, on Stockcharts?
    If you can assist furthur, or know someone who is a current pairs trader, I'd be very happy to hear from either of you!
    Thanks for taking the time to respond, and have a great day.

    Robin ( Johnstone )
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    I am not a Mean Reversion or Pairs Trader. I do know it has specific requirements and specific skills. The Dow Industrials and Dow Transports are indexes that measure two different markets, but they are strongly correlated on all scales (periods). This does seem interesting to keep an eye on in terms of what pair trading means in that weak correlation tends to revert back to its norm of strong correlation.

    You can use the Correlation Coefficient indicator on SCC ( If you bring up chart $INDU, then under indicators drop the "Correlation" indicator. The parameter would be: $TRAN, 20. Then you can change the periods from Daily to Monthly (with a membership plan) to study. For range, use "Fill the chart".

    I read that pair trading suggests strong correlation of .80 or higher, and look for dips below .50.
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    Hi Kevo,

    Thanks. I got as far as Correlation on the drop down, but not sure where to enter $trans, 20 under Parameters. I typed in the symbol in Parameters boxes, then pressed enter, but to no avail.

    Any chance of sending me a screenshot, so I can take it from there, please? I am really keen to pursue this line of enquiry and to be able to see the long term historical correlation. Believe me when I say that in my experience, nothing beats an effective pairs trading strategy for profitability with minimal drawdown! Selling options is probably equally safe, but I have no experience. I like the sound of credit spreads in particular...

    I'm not a subscriber. Are you saying I'm unable to investigate correlation, as a consequence? Remember I'm English and live in the U.K. Different timezone and all that. IF I'm able to research the correlation and it proves to be worthwhile to trade this pair, then I would be strongly tempted to sign up.

    Thanks for your ongoing help, which is appreciated. I realise it takes up your time.....!

    Best wishes.

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    Hi Gord,

    Thanks. I did everything you said re: $INDU and trying to obtain a correlation line with $TRANS. No joy. I copied your screenshot example, so don't know why it refused to display the all important correlation line.
    Is it ONLY possible with a subscription?

    Yours in frustration,

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    It's best to plot each symbol individually first, that just makes sure you are looking at the right symbols. It's also best to use the drop symbol search box to make sure you are getting the right symbol coding, much better than just guessing.

    In this case the symbol for the Dow Jones Transportation index is $TRAN, not $TRANS.
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