Financial markets have been around for a long time. And during all this time, quite a lot of different strategies for trading have appeared. Some percentage among them have shown their inefficiency, and another percentage simply helps to drain the deposit. Today we will not talk about a standard trading strategy like scalping or swing trading, but about the strategy of returning to the average value, also known as market-neutral.
Let’s start with a simple one. As you can understand from the name of the strategy, the main indicator that can be used for its implementation is the moving average or Moving Average (MA). The moving average allows you to calculate the average price of a financial instrument for a certain period of time. Moving Average is the most popular and used indicator of all existing ones, due to its simplicity and informative content. The indicator is superimposed on the chart and from how it is located in relation to the asset price, you can make an assumption about the further movement of the market.
The main parameter of the indicator is the set timeframe. It is set in the parameters and is called “Period” or “Length”. By setting the value to 100 and selecting a daily time frame, the average price for 100 days will be formed.
Return to the average value
Any asset has the property of periodically returning to its average value, which in our case can be a signal to open a position at the moment when the moving average crosses the price:
- If the MA crosses the price from top to bottom, then you can short the asset, the trend is downward.
- If the MA crosses the price from the bottom up, then you can open a long, upward trend.
Long and short trades are closed if the moving average shows conflicting signals. Short trades are closed when the average moving price crosses from top to bottom and the candle that broke through the indicator closes above it. Long trades are closed when the average moving price crosses from the bottom up and the candle that broke through the indicator closes below it. When analyzing with the help of a moving average, the main thing is to take into account the time frame, that is, what period is set in the indicator, the same should be for the candle.
The use of two moving averages with different periods is actively practiced, more often it is MA 50 and MA 100. This is done to reduce the “price noise” in order to see the best moments to enter the market. The moving average, which has fewer periods set in the parameters, is considered more mobile, due to the fact that it is closer to the asset price. The average one, which has more periods, reacts much longer to price changes, so it follows the first one with a slight lag. The right moment to enter the market is determined at the intersection of two averages, namely:
- When the moving average with a smaller period from the bottom up crosses the average with a large number of periods – this is a signal for a long position.
- When the moving average with a smaller period from top to bottom crosses the average with a large number of periods – this is a signal for a short position
In both cases, when the opposite intersection appears, the transactions are closed. However, the use of two or more moving averages when finding a favorable moment to enter the market is not considered reliable. With this approach, according to the assurance of many traders, a lot of false signals appear, which are interpreted as true. Therefore, many market participants prefer only one moving average.
Pair trading: correlation and cointegration
Pair trading is a type of trading strategy based on the correlation between two or more assets. The profit in pair trading is extracted from short-term price discrepancies of correlating assets. For example, it is well known that the share price of oil-producing companies is closely related to oil prices. If oil prices fall, almost synchronously they are followed by shares of oil companies. At the same time, the shares of one company may briefly go against the general market dynamics. As a rule, such independence does not last long and soon the price returns to the general movement. The task of a trader using a pair trading strategy is to find the price discrepancy between two assets, sell the overvalued and buy the undervalued. The closing of transactions occurs when the prices of the two assets are correlated again.
The correlation values range from -1 to 1. The greater the negative value, the lower the correlation:
- 0.0 – 0.2 – low correlation level;
- 0.2 – 0.4-weak correlation;
- 0.4 – 0.7-moderate level;
- 0.7 – 0.9 – high level;
- 0.9-1 is a very high correlation.
For assets whose correlation level is 0.9-1, the concept of cointegrated assets is more often used, which at first glance do not differ from correlating ones, but when examined in detail, they have significant differences.
The essence of integration is to find two assets that do not just rise or fall at about the same time, but move almost synchronously.
For example, bitcoin and Ethereum are correlating assets, since they move in the same direction within the framework of a general market trend. At the same time, changes in their price do not occur synchronously, but in different ways, both in time and in strength. In total, both assets either rose or fell in price, but each in its own way.
Texas Oil (WTI) and the index of shares of American oil companies (USO) are co – integrated assets, since they move not only in the same direction, but also almost 100% synchronously both in time and strength. In total, both assets either rose or fell in price in the same way.
Trading cointegrated assets is considered less risky than trading correlated assets. Why? For example, bitcoin for the first half of 2019 increased by 380%, and ether by 280%. At the same time, the most correlated altcoin with bitcoin – Monero (XMR) increased by 301% and, unlike BTC, on June 26, XMR already turned around for a correction, while bitcoin did it only the next day. Accordingly, a trader may incorrectly interpret or predict the movement of correlating assets and open positions either late or early, thereby receiving a loss.
WTI crude oil in the period from January to April 2019 increased by 48.7%, and the USO index by 46.8%. For the entire period, both assets moved absolutely synchronously.
If you subtract another cointegrated asset from the chart, the resulting difference between it (spread) will always tend to the average (level 0 in the picture) and will not have a pronounced trend.
The difference between correlating assets does not tend to the average and will have a pronounced trend, even if the correlation between assets is very high.
This suggests that in the case of correlating assets, the price divergence is unpredictable, and in the case of co-integrated assets, prices return to the average value for both assets almost always, which makes co-integration less risky when using a return to the average value strategy than trading correlating assets. But why is this happening?
Correlating assets are united by a common market situation. For example, safe-haven assets such as gold, the Japanese yen and the Swiss franc increase in price during crises, recessions and other shocks. They are correlated, but at the same time they are independent of each other and when any fundamental events occur for a particular instrument, they can trade in different directions for a long period of time. This can lead the trader to losses, since the return to the average value is unpredictable.
The cointegrated assets are united by a common instrument, the dynamics of which directly affects the dynamics of the pair. For example, gold and the GDX gold miner stock index. When any fundamental events appear, they fall either synchronously or are traded in different directions, for a short period of time, due to which profit is extracted.
The use of a market-neutral trading strategy can be both a real strategy that brings income, and a certain analytical tool that allows you to look at the situation on the market differently. The task of a trader is to remember one important nuance — the value of an asset always tends to its average value, which can easily be calculated using the good old MA 50 or MA 100. The balance of supply and demand is, in essence, the same average value, the deviation from which occurs as a result of a preponderance towards bulls or bears. The trader’s goal is to use this deviation and earn money until the balance in the market has stabilized. For trading more complex assets, for example, co-integrated, high-frequency HFT trading is used. If there are not enough funds for HFT trading, then you can use the services of RevenueBot.