Correlation and Cointegration:
In pairs trading, both correlation and cointegration are important concepts, but they serve different purposes and convey different types of relationships between two financial instruments. Here's a breakdown of the differences:
Correlation Explained
Correlation is a statistical metric that indicates the degree to which two variables move in tandem. In pairs trading, it gauges the extent to which two securities’ price movements are synchronized.
The range of a correlation coefficient is between -1 and +1. A correlation near +1 signifies a strong positive connection; one near -1 indicates a strong negative relationship; and a correlation near 0 suggests no discernible linear relationship exists.
Correlation can vary over different periods and may evolve over time.
It’s important to recognize that high correlation doesn’t guarantee a consistent long-term relationship between two assets. Even with strong correlation, assets can eventually diverge.
For pairs trading, a high correlation is desirable as it suggests the assets tend to move together. Nonetheless, correlation is not the sole factor to rely on for pairs trading decisions.
Understanding Cointegration
Cointegration refers to a long-term equilibrium relationship between multiple time series, indicating that if they deviate from a common path, they are likely to revert back to it over time.
Unlike correlation, cointegration isn’t measured in a range but rather is a binary condition where time series are either cointegrated or not. Its strength can be assessed through statistical testing.
Cointegration typically reflects a long-term relationship and is less prone to fluctuations over short periods.
Cointegrated assets imply that the difference in their values has a tendency to return to an average value over time, which is a key concept in pairs trading.
In pairs trading, cointegration is often preferred over mere correlation as it suggests a more reliable and statistically significant mean-reverting relationship between a pair of assets.
In Summary
Correlation provides insights into the short-term relationship between two assets, indicating how they move relative to each other at present.
Cointegration is essential for identifying a long-term relationship where two assets demonstrate a mean-reverting spread.
Pairs trading strategies can benefit from selecting pairs that exhibit both strong correlation and cointegration, potentially enhancing the profitability and stability of the trades.