pairs-trading

Cointegration-based pairs trading identifies statistically linked securities, constructs a mean-reverting spread with hedge ratios, and generates entry or exit signals using z-score thresholds to exploit temporary mispricings with reduced market exposure.

Hedge ratios for spread construction can be estimated using ordinary least squares, total least squares, or Kalman filter approaches, each offering different levels of adaptability for capturing the dynamic relationship between paired securities.

Risk management for pairs portfolios involves applying stop-loss levels, periodically re-testing cointegration, enforcing sector exposure limits, and diversifying across 10 to 30 pairs to control drawdowns and reduce concentration risk.

Pairs trading strategies can be applied to stocks, ETFs, and cross-asset pairs by identifying cointegrated relationships, computing formation periods, and monitoring spread mean-reversion across different asset classes.

Re-testing cointegration is necessary when the spread diverges beyond established stop-loss levels or during periodic portfolio rebalancing, ensuring the statistical relationship between the securities remains valid before adjusting positions.