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I am running a mean reversion strategy. I have question with regards to half-life; I have heard of OU process to determine the high life but it's not giving me the kind of result.

Can any one advise on other way to identify half life or else any other indicator that I can use to trade to support my Z score?

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what do you mean by 'it's not giving me the kind of result'? –  MarianP Aug 18 '12 at 22:21
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1 Answer 1

up vote 5 down vote accepted

The OU process is:

http://en.wikipedia.org/wiki/Ornstein-Uhlenbeck_process

Here's an example of the use of the OU method.

http://epchan.blogspot.com/2007/01/what-is-your-stop-loss-strategy.html

To me, the problem is identifying processes that actually have a reason to bleed down to the mean, and that show statistically significant results. If you can identify the "bleeds", then you can build a model of a "bleed". From that, you can determine if the current "bleed" is taking longer than 95% (or whatever % you like) of the "bleeds" that you modeled.

Edit 1 =================================

To illustrate some considerations, I'll use the picture from one of Ernie's examples at this link:

http://epchan.blogspot.com/2006/11/cointegration-of-oih-with-spot-oil.html

As shown below, I added green "entry points" (1 through 7) where you would "get in" as the blue line drops down through the top one-sigma red line. I added red "exit points" (A through C) where you "get out" as the blue line drops through the mean zero line.

enter image description here

As you can see, trades 1-A, 2-B and 5-C are all profitable "bleeds". However, entries 3, 4, 6, 7, (and others that I didn't label) are garbage. You'll have to come up with a way to get out of those positions without wasting too much time and money. The costs of closing out the garbage have to be subtracted from the gains of the bleeds to determine if this pair-trade is worth trading.

Now look at another potential pair:

http://epchan.blogspot.com/2006/11/reader-suggested-possible-trading.html

Using the same general idea, this trade might have less garbage to deal with. My point is, choosing the right pair is probably the most important part of pairs trading.

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Hey, Thanks for your reply, do you have an example of this process in excel file. –  Add May 26 '11 at 16:20
    
@Abhay, I updated my answer to illustrate an example. Also, I'm sorry, but I don't use Excel for these types of calculations. You might consider R. –  bill_080 May 26 '11 at 18:34
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