Trading Pairs Based on Inverse ETFs

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Pair Trading Lab now supports trading pairs assembled of negatively correlated instruments where typically one leg is an inverse ETF. You could trade these pairs with regular strategies (sometimes cointegration is manifested in these cases and backtests look good), but there is one problem with this approach - the strategy is no longer market neutral.

In order to stay market neutral one has to invert signal for one leg - so typically one is either in long position for both legs or in short position for both legs, unline with the regular long/short or short/long scenario.

For practical reasons to get meaningful signals from models, you typically also need to transform prices of one of the leg (to "flip" prices). Pair Trading Lab now supports both features required. The transformation function is typically Pnew = A /Pold + B. These coefficients don't really matter, default values are A=1000, B = 0.5. You just want to transform prices in the way the result looks like a real price and it is not too low or too high. In 99% cases you can stick with these defaults.

Now some example: This is a pair EUM/EWH assembled from regular ETF and an inverse ETF:

You can see prices manifesting negative correlation and β coefficient is negative:

EUM/EWH prices & correlation

For this pair you can see that regular strategies do not appear to have much success:


Now, let's try to look at inverted strategies with transformed prices:


It looks much better! Lets try to backtest one of the strategies with details:

You can see quite stable performance for many years. Look at the price transformation:

EUR/EWH price transformation Pnew = 1000 / Pold + 0.1

You can notice how the price transformation created a virtual instrument leading to positive correlation in the pair. Now see how this combo is being traded with long/long or short/short positions:

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