Question on the spread for Mean Reversion Pairs trading

AI & Machine learning
1

Hi all,



I am working on a simple mean reversion strategy.

Basic steps same as those in the course:

  1. Get a spread for 2 stocks.
  2. Get the moving avg of the spread, Upper band, and Lower band.
  3. Generate Signal base on the moving avg, and upper/lower band.



    Just for the spread part in step 1, I don't understand the difference between this two method:
  4. Use Price Ratio
  • Simply Stcok 1 price / Stock 2 Price… and Use the Ratio to get moving avg, bands for signals.


  1. Use hdege Ratio and portfolio
  • Get the hedge ratio from regression, contract portfolio using that hedge ratio, and then get moving avg on the price of that portfilio with hedge ratio.



    What's the difference between these two?

    They seems give me very similar result. But the first one just much easier.



    Any idea?



    Thanks.

     
2

That's right. Both methods give a very similar result. But the difference is price ratio is a dollar neutral hedge method, and the other one is beta neutral hedge method.



You can read more about these here.

3

HI Vibhu, that's helpful! Thanks…