- Optimal Pairs Trading: A Stochastic Control Approach. Mudchanatongsuk, S., Primbs, J.A., Wong, W. Dept. of Manage. Sci. & Eng., Stanford Univ., Stanford, CA.
- Pairs trading. Elliott, van der Hoek, and Malcolm. Quantitative Finance, 2005
Very briefly, a good mean reversion strategy depends on its ability to:
- estimate the current true/hidden price (the mean) so that we can estimate the disequilibrium
- manage the risk by keep the “optimal” position based on the disequilibrium
In practice, most single assets do not naturally exhibit mean reversion behavior (except maybe over a short horizon). We would thus have to create synthetic assets that mean revert. For example,
One good starting point is cointegration. However, the cointegration criterion, namely stationarity, is a very restrictive concept. It is very difficult to achieve practically. For the sake of making money, this is also unnecessary. What we really need is a concept of “close enough to stationarity so that we can make money”.