I am testing a pair trading strategy. Every day I recalculate the hedge ratio using the past N prices of the 2 underlying. With the hedge ratio, I calculate the past N spreads and do an ADF test to check stationarity. I am wondering how I should treat the case of a negative result. Assuming I was invested in the pair, should I consider that a negative ADF test should trigger an unwind of the position?
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2 Answers
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For pair trading strategy to work (i.e. to start trade/end trade) the spread between your two underlyings should be stationary all the time. Failing ADF test would mean the spread is not stationary anymore.Assuming you are already invested in the pair by some pair strategy decision:
- you should not make further decisions on the trade by pair-strategy rules
- put simple stop-loss /trailing stop-loss / take profit rules on existing position.
- given that stationary of the spread is violated the best is to find another pair of underlyings for next trades.
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ADF test are supposed to have negative values. More negative is the t-statistic the more stationary a time series is. It doesn't indicate unwinding the position.However, if the result start going positive then you may want to rethink your positions.
