Cointegration Is Non The Same Every Minute Correlation

A reader asked me latterly why I believe that liberate energy stock prices (e.g. XLE) are correlated amongst unsmooth crude futures front-month contract (QM). Actually I don’t believe they are necessarily correlated – I solely recollect they are “cointegrated”.

What is the departure betwixt correlation as well as cointegration? If XLE as well as QM were actually correlated, when XLE goes upwards i day, QM would probable acquire upwards too on the same day, as well as vice versa. Their daily (or weekly, or monthly) returns would accept risen or fallen inwards synchrony. But that’s non what my analysis was about. I claim that XLE as well as QM are cointegrated, pregnant that the 2 toll serial cannot wander off inwards reverse directions for real long without coming dorsum to a hateful distance eventually. But it doesn’t hateful that on a daily terra firma the 2 prices accept to motion inwards synchrony at all.

Two hypothetical graphs illustrate the differences. In the outset graph, stock Influenza A virus subtype H5N1 as well as stock B are correlated. You tin encounter that their prices motion inwards the same management almost everyday.

Now catch stock Influenza A virus subtype H5N1 as well as stock C.

Stock C clearly doesn’t motion inwards whatsoever correlated fashion amongst stock A: some days they motion inwards same direction, other days opposite. Most days stock C doesn’t motion at all! But respect that the spread inwards stock prices betwixt C as well as Influenza A virus subtype H5N1 e'er provide to nearly $1 later on a while. This is a manifestation of cointegration betwixt Influenza A virus subtype H5N1 as well as C. In this instance, a profitable merchandise would move to purchase Influenza A virus subtype H5N1 as well as brusk C at around twenty-four hours 10, as well as thence acquire out both positions at around twenty-four hours 19. Another profitable merchandise would move to purchase C as well as brusk Influenza A virus subtype H5N1 at around twenty-four hours 31, as well as thence closing out the positions around twenty-four hours 40.

Cointegration is the foundation upon which distich trading (“statistical arbitrage”) is built. If 2 stocks only motion inwards a correlated manner, in that place may never move whatsoever widening of the spread. Without a temporary widening of the spread inwards either direction, in that place is no chance to brusk (or buy) the spread, as well as no argue to await the spread to revert to the hateful either.

For farther reading:

Alexander, Carol (2001). Market Models: Influenza A virus subtype H5N1 Guide to Financial Data Analysis. John Wiley & Sons.