The Pair Options on Stockpair are constructed of pairs of stocks that have a high positive correlation between them, meaning that both stocks historically tend to move together. Why do pairs have high correlation? Generally because they are from the same industry sector and traded in the same market, so the same factors impact them. Based on the history of correlation between the stocks, it is assumed that when the correlation between the stocks is temporarily weakened, i.e. one stock moves up and the other stocks moves down, the “gap” between the stocks will close and they will eventually return to their correlated path. The strategy is therefore to identify when the “gap” is created and to trade in the assumption that there is a high probability the gap will close or narrow.
Cointegration strategy on Stockpair
Implementing the cointegration strategy has 2 steps:
- Identify a Stock Pair in which the stocks have moved from their correlation and opened a gap.
- Make a trade assuming the stocks will return to their correlated path
Step 1: Finding changes in the movement of a pair
Identifying the Pair which has moved from its correlation can be done based on analyzing the prices of the stock pairs and the charts of the pairs. The trader should look for pairs that have moved away from each other and preferably, a pair in which the stocks have moved away from each other and then back together in a regular pattern.
Step 2: Open a trade
The trade should be opposite to the “gap”. If stock A has performed better than B, in order to close the “gap” stock B will now perform better. Therefore, on the Stockpair platform – the trader should open position on the “lower” stock in the chart, either in Fix options or in Floating options. The goal would be to sell or to reach expiry when the gap is narrowed.
- Identify on the chart a gap between the stocks of a pair
- Trade on the lower stock