advanced-algorithmic-trading

Chapter 27
Cointegration-Based Pairs Trading
using QSTrader
In a previous chapter the concept of cointegration was considered. It was shown how cointegrated
pairs of equities or ETFs could lead to profitable mean-reverting trading opportunities. Two
specific tests were outlined–the Cointegrated Augmented Dickey-Fuller (CADF) test and the
Johansen test–that helped statistically identify cointegrated portfolios.
In this chapter QSTrader will be used to implement an actual trading strategy based on
a (potentially) cointegrating relationship between an equity and an ETF in the commodities
market.
The analysis will begin by forming a hypothesis about a fundamental structural relationship
between the prices of Alcoa Inc., a large aluminum producer, and US natural gas. This structural
relationship will be tested for cointegration via the CADF test using R. It will be shown that
although the prices appear partially correlated, that the null hypothesis of no cointegrating
relationship cannot be rejected.
Despite this a static hedging ratio will be calculated between the two series and a trading
strategy developed, firstly to show how such a strategy might be implemented in QSTrader,
irrespective of performance, and secondly to evalulate the performance on a slightly correlated,
but non-cointegrating pair of assets.
This strategy was inspired by Ernie Chan’s famous GLD-GDX cointegration strategy[32] and a
post[41] by Quantopian CEO, John Fawcett, referencing the smelting of aluminum as a potential
for cointegrated assets.
27.1 The Hypothesis
An extremely important set of processes in chemical engineering are the Bayer process and the
Hall-Héroult process. They are the key steps in smelting aluminum from the raw mineral of
bauxite, via the technique of electrolysis.
Electrolysis requires a substantial amount of electricity, much of which is generated by coal,
hydroelectric, nuclear or combined-cycle gas turbine (CCGT) power. The latter requires natural
gas as its main fuel source. Since the purchase of natural gas for aluminum smelting is likely a
substantial cost for aluminum producers, their profitability is derived in part from the price of
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