During the whole existence of financial markets, there are a great number of trading strategies, some of which have proven their effectiveness over time, but most of them only help to drain the deposits. Today we are not talking about a standard trading strategy such as scalping or swing trading, but about a strategy to return to the average, also known as a market-neutral strategy. It’s a rather complicated strategy, which is quite different from the one published on the network and most likely you will not use it, but despite this, it helps to broaden the trader’s horizons and see the markets in a slightly different light. Let´s analyse what exactly this strategy is.
Let’s start with an easy one. As you can understand from the name of the strategy, the main indicator that can be used for its implementation -is the moving average or Moving Average (MA). Moving Average allows calculating the average price of a financial instrument for a certain period of time. Moving Average — is the most popular and used indicator among all existing ones, due to its simplicity and informative character. The indicator is applied to a chart and the way it’s located relative to the asset price allows us to make an assumption about further market movement.
The main indicator parameter is the set timeframe. It is set in the parameters and called “Period” or “ Length.” By setting the value to 100 and selecting the daily timeframe, the average price for 100 days will be formed.
Return to average value
Any asset has the property to return periodically to its average, which in our case may be a signal to open a position at the moment when the moving average crosses the price:
- If the MA crosses the price from top to bottom, then it’s possible to shorten the asset, a downward trend.
- If the MA crosses the price from bottom to top, then it’s possible to open a long, upward trend.
Short deals are opened when the price crosses the MA from the top-down and the candlestick that broke through the indicator closes below it. Long positions are opened when price crosses MA from the bottom to the top and the candlestick that broke through the indicator closes above it.
It’s actively practiced to use two moving averages, with different periods, more often MA 50 and MA 100. This is used to reduce “price noise” in order to see the best moments to enter the market. A moving average that has less periods in its parameters is considered more mobile due to the fact that it’s closer to the asset price. A moving average that has long periods of time is much more responsive to price changes, so it follows the first one with a slight lag. The necessary moment to enter the market is determined when two averages are crossed, namely:
- When a moving average with a smaller period crosses the average with a larger number of periods from the bottom to the top, it’s a signal for a long position.
- When the moving average with a shorter period from the top to bottom crosses the average with a large number of periods — this is a signal for the short position.
One of the most popular indicators in trading with two MA 50 and 100 is “Golden Cross” and “Death Cross.” In the daytime timeframe when crossing the MA50 from the bottom upwards MA100 has formed the so-called “Golden Cross,” which signals the beginning of an uptrend. In the reverse situation, when MA50 crosses the MA100 from the top downwards, a “Death Cross” is formed, which means a market decline. This indicator is considered to be quite accurate, determining the real situation in the market, but it works with a delay.
In both cases, when the opposite crossover appears, the transactions are closed. However, the use of two or more moving averages when finding a favourable moment for market entry is not considered reliable. In this approach, according to the certified by many traders, there are many false signals, which are interpreted as true. Therefore, many market participants prefer only one moving average, as a more accurate signal can serve as a crossing of the price of MA100, without using MA50.
Pair trading — is a type of trading strategy based on the correlation between two or more assets. Profits in paired trading are derived from short-term price discrepancies between correlated assets. For example, everybody knows that the value of shares of oil-producing companies is closely related to oil prices. If oil quotations fall, shares of oil companies follow almost synchronously. At the same time, shares of one company may briefly go against the general market dynamics. As a rule, such independence doesn’t last long and soon the price returns to the general movement. The task of a trader using a pair trading strategy is to find the price difference between two assets, to sell the overvalued one and buy the underestimated one. Transactions are closed when the prices of the two assets correlate again.
Correlation values range from -1 to 1. The higher the negative value, the lower the correlation:
- 0.0–0.2 — low correlation level;
- 0.2–0.4 — weak correlation;
- 0.4–0.7 — moderate level;
- 0.7–0.9 — high level;
- 0.9–1 — very high correlation.
For assets whose correlation level is 0.9–1, the concept of cointegrated assets is more often used, which at first glance doesn’t seem to differ from the correlating assets, but when considered in detail they have significant differences.
The essence of cointegration is to look for two assets that not only grow or fall around the same time but move almost synchronously.
Bitcoin and Ethereum, for example, are correlated assets as they move in the same direction within a common market trend. At the same time, changes in their price occur not synchronously, but in different ways, both in time and strength. In total, both assets have either risen or fallen in price, but each in its own way.
Texas Oil (WTI) and the U.S. Equities Index (USO) are cointegrated assets, as they move not only in a single direction, but almost 100% synchronously in both time and strength. In total, both assets have either risen or fallen in price equally.
Trading on cointegrated assets is considered less risky than trading on correlated assets. Why? For example, Bitcoin grew by 380% in the first half of 2019, and Ethereum by 280%. At the same time, the most bitcoin-correlated altcoin — Monero (XMR) — rose by 301%, and, unlike BTC, on June 26, XMR has already reversed the correction, while Bitcoin did it only the next day. Accordingly, a trader may misinterpret or predict the movement of correlated assets and open positions either late or early, thus making a loss.
WTI oil rose by 48.7% between January and April 2019, while the USO index rose by 46.8%. Both assets moved absolutely synchronously during the whole period.
If we subtract one cointegrated asset from the chart of the other, the resulting difference between them (spread) will always tend to the average (level 0 in the picture) and will not have a pronounced trend.
The difference between correlated assets doesn’t tend to the average and will have a pronounced trend, even if the correlation between assets is very high.
This suggests that in the case of correlated assets the price divergence is unpredictable, and in the case of cointegrated assets the prices return to the average for both assets almost always, which makes the cointegration less risky when using a strategy of returning to the average than trading in correlated assets. But why does this happen?
Correlating assets are united by a common market situation. For example, shelter assets such as gold, the Japanese yen, and the Swiss franc rose in value during crises, recessions, and other shocks. They are correlated, but independent of each other and if any fundamental events occur in a particular instrument, they may trade in a different direction for a long period of time. This can lead to losses for the trader as the return to the average is unpredictable.
Cointegrated assets combine a common instrument, the dynamics of which directly depends on the dynamics of the pair. For example, gold and stock index of gold miners GDX. If there are any fundamental events, they fall either synchronously or trade in a different direction, but a short period of time, due to which the profit is made.
The use of a market-neutral trading strategy can be a really profitable strategy, as well as a certain analytical tool, which allows looking at the market situation differently. A trader’s task is to remember one important nuance — the value of an asset always tends to its average value, which can be easily calculated using the good old MA 50 or MA 100. The supply and demand balance is, in essence, the same average value, which deviates from which occurs as a result of an excess in favour of bulls or bears. The trader’s goal — is to use this deviation and to earn before the balance in the market stabilises. For trading more complex assets, e.g. cointegrated assets, high-frequency HFT trading is used.
Please don’t forget to follow us on Telegram and stay updated!
YOUR CRYPTO BOSS