Pairs Trading by the Numbers: Spreads, Hedge Ratios, Mean-Reversion Tests, Z-Score Signals, Half-Lives, Backtests & Trading Costs
Test whether two prices really move together before trusting a spread. You will normalise two fictional price series, estimate a hedge ratio, build the spread, check it for mean reversion with a simple test against a fictional critical-value table, turn it into z-score entry and exit signals, estimate the half-life, backtest positions with costs and stress-test the rules out of sample, with every cell checked as you go.
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About this course
This course works through a pairs idea cell by cell with two fictional price series. You normalise both prices, compute log returns and write out their correlation with SUMPRODUCT. You estimate the hedge ratio with SLOPE, write the intercept by hand and build the spread. A regression of the daily change on yesterday's spread, with the standard error written out, is compared with a fictional critical-value table. You then calculate rolling z-scores and entry, exit and stop labels, the half-life of mean reversion, a position column that remembers yesterday, daily P&L, trading costs, borrow fees and maximum drawdown, and finish with an in-sample versus out-of-sample check. Illustrative numbers, not investment advice.
Lessons
- Two Price Series: Normalising, Log Returns and a Correlation Written Out Pro
- The Hedge Ratio: SLOPE, the Intercept by Hand and the Spread Pro
- Is the Spread Mean-Reverting? A Regression Test Against a Fictional Table Pro
- Z-Score Signals: Rolling Mean and σ, Entry, Exit and Stop Levels Pro
- Half-Life of Mean Reversion: Sizing the Look-Back Window and the Holding Limit Pro
- Positions and P&L: A State Column, Units per Leg and the Daily Result Pro
- Costs and Capital: Trading Costs, Borrow Fees, Trade Count and Maximum Drawdown Pro
- Capstone: In-Sample vs Out-of-Sample, a Drifting Hedge Ratio and a Threshold Grid Pro