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Let's say through different means, I have a factor which is fairly correlated with price. How can I create a trading strategy using this information? How can I generate buy and sell signals given a factor?

An example would be this: taking DE10Year yield minus US10Year yield, the spread shows strong correlation visually with EURUSD price. How can we generate a buy sell?

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So supposedly you have

  1. tested the properties of the two time series
  2. passed cointegration test
  3. and you are sure that the correlation in this data period was not driven by a very obvious macroeconomics factor, then it comes to defining your investment strategy.

A common one is pairs trading, where you remain cashless in longing one asset and shorting the other. There are lots of ways to do pairs trading, but as a starter let's say you defined the spread $\epsilon_t $ between asset A and B (counting the ratio mentioned earlier to maintain cashless), since we think there's long run equilibrium between the two asset, $\epsilon$ series should follow normal distribution like a noise.

Your buy/sell signal then can be: once the spread exceeds say 2 standard deviation, we think the current spread is overvalued and thus we short the asset as the subtractor in our equation defining spread (e.g $\epsilon$ = A- some ratio * B, in this case asset A) and long the other one, vice versa on -2 std.

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If two different assets are highly correlated this means the correlation will be already in the price. Unless you find a correlation like $X\left[t\right] = Y\left[t+2\right]$.

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