Pair trading using correlation

Correlation of the movement of currency assets can be used not only on older timeframes to determine general market trends, since often one of the pairs included in it acts as a leading indicator in relation to the other.

Getting initial data

The pairs for which we will trade are determined by the current correlation coefficients. There are many calculation algorithms, in spite of the external evidence of the process, as well as the services that publish them. From reliable sources, we can single out the well-known site, on which we will develop a strategy.

The closer the result is to one (or -1 in the case of a reverse movement), the stronger the current relationship with the asset and a natural question arises – are 0.85 enough presented to start pair trading or wait for large values? There is no unequivocal answer to this question, however, this is typical for any method of market analysis. But if you remember that “full” 1 / -1 is more of a theory, then this ratio is quite enough.

The next step will be to analyze the dynamics of changes in funds for open positions over the past month. We look at the amount for open, not closed deals.

The goal is to determine the value of the average drawdown for the specified period. In our case, that’s $ 5:

  • If one of the pairs has grown by + 5 dollars, this is a signal that the total spread tends to zero;
  • With a further rise in the price to +10 and above, the actual spread will be around +5 dollars.

We start trading

We start trading

Pair trading is a fairly simple strategy that is quite accessible to beginners. After the pairs are selected and the average drawdown level is determined, we do the following:

  • open two trades with a volume of 0.01 lot. In our case, this is BUY for GBP / USD and SELL for GBP / CHF. Based on these positions, we will determine the entry point by the main volume, therefore we will call them “indicator”;
  • waiting for the total result on indicator trades to reach the level of +/- $ 5 or higher. This will be our entry point, we open the main positions of 0.03 lots – SELL for GBP / USD and BUY for GBP / CHF;
  • the price will tend to close the resulting spread, and when the profit / loss on indicator trades approaches zero, close the main ones. Then the cycle is repeated.

As you can see, there is nothing complicated, the main thing is to enter only at the moments when the correlation spread reaches the required values. A positive result will be only with strict adherence to the rules of the strategy. Searching for chart patterns and using additional indicators will only distract the trader’s attention.

Recommendations for using pair trading:

  • do not forget that the size of the correlation coefficient depends on the timeframe. The daily interval can show a value close to one, but within a day this is completely optional. Couples can walk in different directions for a rather long time, and then give a good final value with a strong synchronized movement. Therefore, check the data at different intervals and information services!
  • From the previous point it follows that intraday correlations quickly “collapse”, but this does not mean that they cannot be earned. You just need to carefully calculate at what levels the drawdown / profit will tend to the initial values ​​on lower timeframes.
  • The examples given in the video used the Forex market tester, which can be accelerated if desired, since it takes a long time for indicator trades to show the entry / exit point. Not everyone can afford to spend that much time in front of the terminal. To reduce the likelihood of an error, use automatic advisors, especially since the strategy does not require the use of complex indicators.