Market neutral strategies often rely on a relative mispricing of two instruments. One of the challenges I've been facing is how to keep this mispricing constant in time, allowing it to stretch much further before initiating a trade in times of high market volatility.
A solution I've come up with is using the VIX index as a correction measure. It seems to work much better than a moving window estimation based on the data itself. The formula I'm using for correction is C = (100-VIX)/100 . The spread is then multiplied by C.
Upper graph: VIX , lower graph : real and corected spreads.
Notice how the corrected spread remains stable through the end of 2008.
P.S. The spread shown is a relative mispricing in time an not an actual X/Y ratio.
I like this concept - what spread is it you are testing there? It looks very stable indeed!
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Ramon
@Ramon: I've anticipated the question about the spread stability ... To disappoint you a little, it is not an 'absolute' spread (X/Y), but rather a relative spread (movingAverate(X-Y)). The absolute spread has pretty much drift, however, it is still very tradeable.
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