Using the Kalman Filter
Using the Kalman filter for pairs trading involves tracking the spread or the price difference between two correlated assets, which are part of a pairs trading strategy. The Kalman filter can help you estimate this spread and make trading decisions based on it. Here's how you can use the Kalman filter for pairs trading:
Select a Pairs of Assets: Choose a pair of assets that are expected to be cointegrated, meaning their prices move together over time. For example, you can choose two stocks from the same sector or two commodities with a historical relationship.
Define the Spread: Calculate the spread (price difference) between the two assets. The spread is the quantity you want to estimate using the Kalman filter. The spread could be as simple as the price difference between the two assets.
Set Up the Kalman Filter:
Define the state variables: In this case, the state variables would be the spread between the two assets.
Define the state transition model: Describe how the spread evolves over time. It could be a simple model like the spread at time t is the spread at time t-1 plus some drift or mean-reversion term.
Define the measurement model: This relates the observed spread to the true spread plus some measurement noise.
Initialize the Kalman Filter: Set the initial state estimate, covariance matrix, and noise parameters.
Predict and Update:
In the prediction step, use the state transition model to predict the next spread value.
In the update step, compare the predicted spread with the actual observed spread (from the two assets). Update the state estimate and covariance matrix using the Kalman filter equations.
Trading Strategy: Make trading decisions based on the estimated spread. For example, if the estimated spread is significantly higher or lower than historical averages, you might take long and short positions in the assets to capitalize on the expected convergence of the spread.
Here’s a simplified Python code example for pairs trading using the Kalman filter:
import numpy as np
from pykalman import KalmanFilter
# Simulated spread data (replace with your data)
spread_data = np.random.randn(100) * 2
# Define the Kalman filter
kf = KalmanFilter(initial_state_mean=0, n_dim_obs=1)
# Fit the filter to the spread data
kf = kf.em(spread_data, n_iter=10) # You can adjust the number of iterations
# Predict the spread values
filtered_state_means, _ = kf.filter(spread_data)
# Implement your trading strategy based on the estimated spread
# For example, you can enter long and short positions when the spread crosses certain thresholds.
