Cointegration Mean Reversion

Entry Logic

• Long Entry: The spread between two cointegrated assets widens to a statistically significant level. Buy the underperforming asset and sell the overperforming asset.
• Short Entry: Not applicable.
• Confirmation: The spread begins to revert to its mean.
• Timeframe: Daily.
• Location: Extreme deviation in the spread of a cointegrated pair.
• Market Condition: Any.

Exit Logic

• Profit Target: The spread returns to its mean.
• Scaling Out: No.
• Trailing Stop: No.
• Signal Failure: Exit if the spread continues to widen.
• Opposite Signal: Not applicable.
• Time Expiration: Hold as long as the cointegration relationship holds.
• Momentum Loss: Exit if the reversion stalls.

Stop Loss Structure

• Hard Stop: A pre-defined maximum spread width, determined by backtesting.
• Soft Stop: If the cointegration test (e.g., Augmented Dickey-Fuller test) fails.
• Max Dollar Loss: Varies.
• Max Percent Loss: 4%.
• Structural Stop: Not applicable.

Risk Management Framework

• Risk Per Trade: 2%.
• Daily Limit: Not applicable.
• Weekly Limit: 6%.
• Max Drawdown: 20%.
• R:R Requirement: 2:1.

Position Sizing Model

• Sizing Approach: Based on the hedge ratio determined by the cointegration analysis.
• Volatility Adjustment: No.
• Conviction Sizing: No.
• Scaling In: No.
• Scaling Out: No.

Trade Filtering

• Market Conditions: Requires a statistically significant cointegration relationship.
• Setups: Based on a cointegration test.
• Instruments: Any pair of assets that have a long-term economic relationship (e.g., different classes of oil, different government bonds).
• Time Restrictions: None.
• Chop/News Avoidance: Be aware of news that could break the economic link between the assets.

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: Not applicable.

Trade Management Rules

• Breakeven: No.
• Scale Out: No.
• Add Size: No.
• Fast vs Slow Moves: This is a very slow-moving, long-term strategy.

Time Rules

• Optimal Window: Any.
• Times to Avoid: None.
• Session Notes: A sophisticated quantitative strategy.

Setup Classification

• A+ Setup: A strong cointegration relationship with a large deviation from the mean.
• A Setup: A moderate cointegration relationship with a moderate deviation.
• B Setup: A weak cointegration relationship.
• C Setup: No cointegration.

Market Selection Criteria

• Instruments: Pairs that pass a cointegration test with a high degree of confidence.
• Volume: High.
• Volatility: Any.

Statistical Edge Metrics

• Win Rate: 70-80%.
• Avg Win: 2.5R.
• Avg Loss: 1R.
• Profit Factor: 3.0.
• Expectancy: +1.25R.

Failure Conditions

• Market Conditions: A breakdown in the fundamental economic relationship between the two assets.
• Specific Scenarios: A technological innovation that makes one asset obsolete.

Psychological Rules

• Discipline: Requires a deep understanding of statistics and econometrics. Must trust the model.

Advanced Components

• Regime Detection: The cointegration test itself is a form of regime detection.
• Filters: Only trade pairs with a stable cointegration relationship over a long period.
• Correlation: Cointegration is a more specific and powerful concept than correlation.
• MTF Alignment: Not applicable.

Location

• Strongest: In markets where there are strong, stable economic links between assets.
• Weakest: In markets where assets are driven by speculation rather than fundamentals.