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I am interested in implementing a simple pairs trading strategy using two correlated futures contracts. I am unsure what the best way to normalize the prices of the two instruments is.

Essentially right now I am iterating concurrently through the prices of two instruments however the prices are on very different scales and the two contracts have different minimum tick price increments.

What is the best way to normalize the prices so that I can compute the difference in between prices in order to determine if there is a significant spread present?

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    $\begingroup$ that's one reason, why people use returns.. $\endgroup$ – LazyCat Apr 7 '17 at 13:53
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Normalize by assuming both prices at t(1) = 1, and then multiply every t by (1 + price change in %) to get normalized price at t+1. Difference in tick size does not matter it will just make the spread volatility larger. However you will have to account for that tick size when you back test.

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Do a linear regression of security 1 versus security 2 and the slope is the hedge ratio.

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