Mean Reversion Strategies Flashcards
Mean Reversion
A theory which assumes that after an extreme price move, asset prices will return their long-term mean or average.
Spread
Not limited to the difference between the best ask and the best bid, and in general, a spread refers to the difference or gap between two prices, rates, or profits/losses.
Interdelivery Spread
Between different months of the same commodity.
Intercommodity Spread
Between the same or related commodities, usually for the same month.
Intermarket Spread
Between the same or related commodities traded on two different exchanges.
What does spread tell us?
Prices of two related commodities should be relatively stable (may not be at the same scale) with respect to each other.
If you find the two curves deviate (the absolute value of the spread increases), that means one becomes relatively cheaper or another becomes relatively more expensive.
Spread Trading
Involves simultaneously buying and selling related multiple securities or contracts to profit from the price difference between them.
Spread trading is designed to capitalize on relative price
movements rather than outright price direction.
Weighted Linear Combination
Spread = price1 - weight * price2
Scaling
When we create a spread, we hope to rescale one of the two-time series in a way (i.e., find some weights)
such that the difference between two plots is on similar scales.
Linear Regression
Captures the ratio between the expected price moves of the constituent price series.
Spread Strategy
If we succeed we can then buy the spread (long the cheap product and short the expensive one) whenever the spread drops far below its mean and sell the spread whenever it goes too high above its mean.
Advantage of Spread Trading
Mitigate market risk: Traders can profit from the price differentials regardless of the overall market direction. (But still suffer from market risk.)
