Use Economic Links to Screen Cointegrated Pairs

Summary

The document discusses how to reduce the risk of trading spurious cointegration by screening candidate assets for economic relationships. It recommends looking for securities with strong ties, such as related commodity benchmarks, a commodity and associated companies, or an equity index future and its constituents. Such links may provide a rationale for expecting a durable long run relationship before testing short term deviations.

The proposed trading intuition is that temporary divergence may offer an opportunity when the long run relationship remains robust. However, the answers are brief opinions rather than a selection procedure or empirical study. One cautions that simple pairs trading yields have declined and suggests spurious cases may become a last resort; another questions whether cointegration itself adds value once the underlying economics are understood. No statistical tests, controls for multiple comparisons, or performance evidence are supplied, so economic ties are a screening rationale, not proof that a pair will remain cointegrated.

Key ideas

• Screen candidate pairs for a clear economic relationship before testing cointegration.
• Related commodities, producers, and index futures with constituents are examples of economically linked combinations.
• The trading intuition is to exploit short term divergence while a long run relationship remains robust.
• Economic rationale can reduce reliance on potentially spurious statistical relationships.
• The discussion gives opinions but no formal selection method or performance evidence.

Tags

# Cointegration trading: Ignoring pairs that aren't economically related


# Cointegration trading: Ignoring pairs that aren't economically related












Cointegration trading question

What's the state of the art when it comes to choosing proper subsets of stocks/assets where cointegrating relationships aren't ignored as (likely to be) spurious?

For example, we wouldn't want to trade a Chinese stock of a fast food franchise with an Australian mining company because a cointegrating relationship could too easily be due to a type I error. But you might want to trade two Australian mining stocks because they share risk factors, reducing the probability that your cointegrating relationship is spurious.

What's the best way to approach this? Informed opinions welcome.

## Answer by dkhokhlov (score 1)

https://quant.stackexchange.com/a/4534

Simple pairs trading yield is falling every year. It is now at the level when "spurious" cointegration cases become a last resort.

## Answer by Rock (score 1)

https://quant.stackexchange.com/a/4769

You want to find combinations (2+) of securities with strong economic ties, e.g. WTI/Brent crude, gold/goldMiners, DJIA futures / component stocks, etc.

The theoretical edge would come from the break down in correlation between the combinations in the short run, if their long run correlations remain robust. It's likely that once you understand where the money is, you'd see that cointegration doesn't really add any value.

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