wrong pair trading rules?

[Emérito Pelayo]

We were discussing that, if you loof for the most profitable pairs with the pre-screened pair tool, you will see that most of the best pairs profit comes from one big movement of one of the shares. it's maybe a Google finance error, or maybe it's a real movemente, it doesn't matter, the problem is not that.

The problem is: how can a "mean reverting" strategy make money with those big movements AGAINST the mean???. You have the ratio between two shares, you have a mean of that ratio, and you have the bollinger bands of that ratio. The strategy should be:

- The ratio should go down to the mean when it croos below, FROM UP TO DOWN, the UPPER band, so you will open the orders to bet to that.

- The ratio sould go up to the mean when it cross above, FROM DOWN TO UP, the LOWER ban, so you will open the orders to bet to that.


That should be the right way, so.....there is something wrong with the calculations of all the pair trading strategies of the site....I will continue investigating.

[admin]

The problem is: how can a "mean reverting" strategy make money with those big movements AGAINST the mean???

Hello Emérito,

if I understand right, you are asking how could possibly a pair trading strategy make money in case one of the legs price moves by extreme amount, because this move moves the ratio against the mean.
This can easily happen in case you are already in pair position, and one of the legs gaps overnight in "your" direction.

Check this example:
https://www.pairtradinglab.com/backtests/US9qV1vTcEyuRKKC

2011-12-14   NYSE:RRR   Buy   11.00   -2.309   5.485   1097   0.00   0.00
2011-12-14   NYSE:STON   Sell   24.91   -2.309   2.42   484   0.00   0.00
2011-12-16   NYSE:RRR   Close   11.00   12.760   5.485   1097   17.95   7624.15
2011-12-16   NYSE:STON   Close   24.91   12.760   2.42   484   25.64   -353.32

Position got opened 2011-12-14 (RRR bought @11.00), closed 2 days later (RRR sold @17.95). So it can happen, if you are lucky enough
It happened to me in live trading, but unfortunately the other way around (one leg went 40% against my position overnight).

[Emérito Pelayo]

....ok, I undestand now, I will be carefull with that.