How does pairs trading use cointegration, and how is it different from correlation?

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Pairs trading is a market-neutral strategy that exploits temporary mispricings between two historically related securiti...

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**Correlation vs Cointegration:**
- **Correlation** measures how two price series move together in direction (up/down) over short periods
- **Cointegration** means two non-stationary price series share a long-run equilibrium relationship -- their spread is mean-reverting even though individual prices are not stationary

Two stocks can have low correlation but be cointegrated (they wander apart and come back together), or high correlation but no cointegration (they trend together but the spread can diverge permanently).

**Setting up a pairs trade:**

1. **Screen for candidates** -- Same industry, similar business models
2. **Test for cointegration** -- Engle-Granger test or Johansen test on historical prices
3. **Estimate the hedge ratio** -- Regression coefficient (how many shares of stock B to short per share of stock A long)
4. **Monitor the spread** -- Z-score of the spread from its mean
5. **Enter when spread diverges** -- Typically at +/- 2 standard deviations
6. **Exit when spread reverts** -- Back to the mean (z-score near 0)

**Example -- Oakmont Pharma vs. Bellevue Therapeutics (fictional):**

Regression: Price_Oakmont = 1.3 x Price_Bellevue + constant. Spread mean = $2.50, SD = $1.20.

Current spread = $5.10 --> Z-score = (5.10 - 2.50) / 1.20 = **2.17** --> Signal to short Oakmont, long 1.3 shares of Bellevue per share of Oakmont shorted.

**Risks:** Cointegration can break down permanently (structural change, M&A, regulatory shift). The spread can widen further before reverting, creating margin pressure. Always use stop-losses at 3+ standard deviations.

How does pairs trading use cointegration, and how is it different from correlation?

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