Classic Pairs Trading:
In the context of Forex pairs trading, the following criteria are generally considered to determine suitability:
High Correlation: Desired Range: Approaching +1 or -1
Justification: A pronounced positive or negative correlation signifies that the currency pairs move in tandem or inversely, a key for pairs trading.
Cointegration: Desired Threshold: p-value below 0.05 (or your selected level of significance)
Justification: Cointegration, indicating a mean-reverting spread between pairs, is a stronger relationship than correlation and vital for pairs trading.
Spread Stability: Desired Condition: Low fluctuation in the spread
Justification: A consistent spread simplifies the determination of entry and exit points for trades.
Liquidity: Desired Condition: High transaction volume
Justification: High liquidity ensures trades can be executed without significantly affecting market price.
Transaction Costs: Desired Condition: Minimal
Justification: Reduced costs like spreads and commissions enhance the profitability of the strategy.
Risk Factors: Desired Condition: Manageable volatility or risk
Justification: Lower risk equates to more predictable strategy performance and easier management.
Historical Performance: Desired Outcome: Proven success in backtesting
Justification: Past success, while not definitive, suggests potential for future profitability.
Sharpe Ratio: Desired Benchmark: Above 1, the more elevated, the better
Justification: An increased Sharpe ratio signals superior risk-adjusted returns.
Drawdown: Desired Level: Minimal
Justification: A modest drawdown implies reduced potential for capital loss during unfavorable market conditions, which bolsters the strategy’s resilience.
Market Conditions: Desired Strategy Characteristic: Market-neutrality
Justification: A strategy that is immune to general market movements is inherently more stable.
In your analysis of currency pairs for trading, statistical measures and performance indicators are typically employed to evaluate these aspects. For instance, the Pearson correlation coefficient might be used to gauge correlation, while the Augmented Dickey-Fuller test would assess cointegration. Additionally, you’d scrutinize backtesting results to assess historical efficacy, Sharpe ratio, and drawdown levels.
These criteria assist in systematically pinpointing Forex pairs that are apt for pairs trading.