Pairs Mean Reversion (Spread Trade)

Entry Logic

• Long Entry: The spread between two correlated assets widens to a statistically significant level (e.g., 2 standard deviations).
• Short Entry: The spread between two correlated assets narrows to a statistically significant level.
• Confirmation: The spread begins to revert to its mean.
• Timeframe: 60-minute or daily.
• Location: Extreme deviation in the spread.
• Market Condition: Ranging or trending, as long as the correlation holds.

Exit Logic

• Profit Target: The spread returns to its historical mean.
• Scaling Out: No.
• Trailing Stop: No.
• Signal Failure: Exit if the spread widens to 3 standard deviations.
• Opposite Signal: Not applicable.
• Time Expiration: Hold as long as the reversion is in progress.
• Momentum Loss: Exit if the spread stalls.

Stop Loss Structure

• Hard Stop: A 3 standard deviation move in the spread against you.
• Soft Stop: If the correlation between the two assets breaks down.
• Max Dollar Loss: Varies based on the pair.
• Max Percent Loss: 2% of account.
• Structural Stop: Not applicable.

Risk Management Framework

• Risk Per Trade: 1%.
• Daily Limit: Not applicable.
• Weekly Limit: 5%.
• Max Drawdown: 15%.
• R:R Requirement: 2:1.

Position Sizing Model

• Sizing Approach: Dollar-neutral pairs (long one asset, short the other with equal dollar amounts).
• Volatility Adjustment: The spread itself is a measure of relative volatility.
• Conviction Sizing: No.
• Scaling In: No.
• Scaling Out: No.

Trade Filtering

• Market Conditions: Requires a stable correlation between the two assets.
• Setups: Look for a clear deviation from the mean in the spread.
• Instruments: Correlated stocks (e.g., KO vs. PEP), ETFs (e.g., GLD vs. GDX), or futures.
• Time Restrictions: None.
• Chop/News Avoidance: Be aware of news that could affect one asset but not the other.

Context Framework

• Trend Direction: Not applicable.
• VWAP Relationship: Not applicable.
• MA Relationship: Not applicable.
• Range Location: At an extreme of the spread's range.
• Higher TF Alignment: The daily chart should confirm the long-term correlation.

Trade Management Rules

• Breakeven: No.
• Scale Out: No.
• Add Size: No.
• Fast vs Slow Moves: Works for both.

Time Rules

• Optimal Window: Any.
• Times to Avoid: Around earnings announcements for either stock.
• Session Notes: A classic quantitative strategy.

Setup Classification

• A+ Setup: A 2.5 standard deviation move in the spread of a historically stable pair.
• A Setup: A 2 standard deviation move.
• B Setup: A 1.5 standard deviation move.
• C Setup: A 1 standard deviation move.

Market Selection Criteria

• Instruments: Pairs with a correlation coefficient of 0.8 or higher.
• Volume: High.
• Volatility: Similar volatility profiles.

Statistical Edge Metrics

• Win Rate: 70-80%.
• Avg Win: 1.5R.
• Avg Loss: 1R.
• Profit Factor: 2.5.
• Expectancy: +0.75R.

Failure Conditions

• Market Conditions: A breakdown in the historical correlation.
• Specific Scenarios: A merger or acquisition involving one of the companies.

Psychological Rules

• Discipline: Must be managed as a single position (the spread), not as two separate trades.

Advanced Components

• Regime Detection: Use a rolling correlation to monitor the stability of the pair.
• Filters: Avoid pairs with low liquidity.
• Correlation: The entire strategy is based on correlation.
• MTF Alignment: Not applicable.

Location

• Strongest: In mature, stable markets.
• Weakest: In times of market turmoil or crisis.