Cointegration in forex pairs trading is a valuable tool. For me, cointegration is the foundation for an excellent cointegrated forex pairs most volatile-neutral mechanical trading strategy that allows me to profit in any economic environment.
Whether a market is in an uptrend, downtrend or simply moving sideways, forex pairs trading allows me to harvest gains year-round. A forex pairs trading strategy that utilizes cointegration is classified as a form of convergence trading based on statistical arbitrage and reversion to mean. This type of strategy was first popularized by a quantitative trading team at Morgan Stanley in the 1980s using stock pairs, although I and other traders have found it also works very well for forex pairs trading, too. Stated simply, when two or more forex pairs are cointegrated, it means the price spread between the separate forex pairs tends to revert to its mean value consistently over time.
It’s important to understand that cointegration is not correlation. Correlation is a short-term relationship regarding co-movements of prices. Correlation means that individual prices move together. Although correlation is relied upon by some traders, by itself it’s an untrustworthy tool. On the other hand, cointegration is a longer-term relationship with co-movements of prices, in which the prices move together yet within certain ranges or spreads, as if tethered together.