Am Not Convinced…
One view I have of the markets is (and is shared by many, many people) is that one cannot, just cannot apply mathematics to a sequence of numbers that are generated based on people’s perceptions (buy and sell). I am not saying that the numbers are random: I am only saying that mathematics cannot be used to predict anything about the markets. This, even if you exclude black swan events.
So, whenever I read a concept, I tend to ask, what is the logic behind this? Why is this an indicator? Let me give an example. Institutions buy puts to hedge their large holdings. So if you suddenly see a spike in puts, that means probably someone is taking a huge long position in the underlying, and is trying to cover the downside with the put. Now this, to me, makes sense.
I am searching for a similar logic as to why pairs should work. I am not going to deploy any of the pair trading strategies unless i am convinced that mean reversion of the price ratio of two entities happens for a reason. As of now, I am not convinced. The only point that I can think of is, since pairs are typically from the same sector, logically, even if in the short run one firm does”better than usual” relative to the other firm, in the medium to long run, the other should catch up, and the performance of the two firms should revert to the mean.
But thats insufficient explanation. I am looking out for more, and will post as I find them.
1 year ago