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Choose Pairs Trading Spreads That Match the Intended Position

Article Quant Q&A · Author: benito.cano
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Summary

The document compares constructing a pairs trading spread from a price difference with using a price ratio. Its practical answer is to calculate the spread for the position the strategy will actually trade, since alternative leg weightings produce different spread behavior.

The response notes that charts based on different combinations may share broadly similar peaks and valleys, while daily returns, volatility, and spread changes can differ. It illustrates this with two stocks at different prices and unequal daily percentage moves: the change in the spread depends on whether the position uses equal shares or a weighted combination. The discussion is practical rather than theoretical, and gives no formal cointegration test, estimation procedure, or performance evidence. A spread definition should therefore be aligned with the actual trading weights and entry and exit rules.

Key ideas

  • Different price differences and ratios encode different combinations of the pair's assets.
  • Broad chart patterns can look similar even when daily spread changes and volatility differ.
  • The spread's behavior depends on the position weights and the component stocks' returns.
  • Entry and exit criteria should be defined for the spread corresponding to the intended position.
  • The response gives practical guidance but no formal statistical method or strategy results.

Tags

EquitiesPairs tradingStatistics
Full text
# Should I calculate a spread using stock prices or the ratio?


# Should I calculate a spread using stock prices or the ratio?












So I am creating a trading algorithm thats uses cointegration, for a pairs trading strategy. Imagine there is stock A for 100 dollars and stock B for 25 dollars. My questions is when caulcating the spread, should I calculate the spread of the prices which would be $75, or should I use the A:B ratio of 4. Does it matter? Is one better than the other? Whats the difference? Thanks!

## Answer by Bob Baerker (score 1, accepted)

https://quant.stackexchange.com/a/59138

I can't help you with any theory since that's above my pay grade. All I can offer is some practical experience from my pairs trading.

In a macro sense, the 1:1 and 4:1 graphs over time will have a somewhat similar shape with peaks and valleys somewhat tending to line up (the granular data will determine that). For discussion, let's assume daily data. However, because the daily ROC of each component is different, the daily volatility and ROC will be different for the respective graphs.

For example, if A at \$25 moves up 1% today and B at \$100 moves up 2% today, the the spread width of the 1:1 increases by \$1.75 whereas the spread width of the 4:1 increases by \$1.00 . If you have some criteria for entry and exit, they should be relevant to the actual position.

My short answer is to suggest that you program the spread that you will be trading not the spread data of another pair combination.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.