Definition
Cointegration
Cointegration is a statistical property where two or more non-stationary price series move together over the long run such that a particular linear combination of them is stationary and mean-reverting.
Cointegration is the rigorous foundation for pairs trading and statistical arbitrage: if two Indian stocks' prices are cointegrated, their spread tends to revert to equilibrium even though each price individually wanders. Traders test for cointegration before trusting a pair, rather than relying on mere correlation.
The danger is that a relationship that was cointegrated historically can break, for example when one company's fundamentals change. Robust strategies re-test cointegration over time, size positions conservatively, and use stop-losses to protect against a spread that diverges instead of reverting.
Related terms
- Pairs TradingPairs trading is a market-neutral strategy that goes long one security and short a related one when their historical price relationship diverges, betting that the spread will revert to its mean.
- Statistical ArbitrageStatistical arbitrage is a class of quantitative strategies that exploit short-term, statistically predictable price relationships across many securities, holding diversified long and short positions to harvest small mispricings.
- Mean Reversion StrategyA mean reversion strategy assumes that prices or spreads that deviate from a historical average will tend to return to it, so it sells what has risen sharply and buys what has fallen.
- Market-Neutral StrategyA market-neutral strategy balances long and short positions so that the portfolio has little or no net exposure to broad market movements, isolating the manager's stock-selection skill.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.