Forex pairs trading strategy exploits cointegration tecniques and it is a convergence trading strategy based on statistical arbitrage using a mean-reversion logic, which is the following: if two pairs are cointegrated, the spread between them will converge sooner or later over time based on an empirical evidence. This does not necessary mean that divergence is about to stop anytime soon, however some traders consider when divergence is high it is the right time to act, attempting to buy one pair and sell the other and waiting for a convergence to happen.
Unless the co-movements between the two currencies break over time, the ‘net’ trade should be zero in the bad scenario. One fundamental property that pairs trading requires is the instruments have to be cointegrated in order to ensure a connection between two FX currency pairs.
FX empirical evidence suggests to use EURUSD and GBPUSD as a suitable pairs because it shows that the chart of these two pairs over the past show the two series co-move together. The only period where the regime shifted was during the Great Financial crisis, when the Cable plunged by -36,0% whereas EURUSD suffered a -23,0% drawdown.
A positive aspect of the currency pairs’ trading is that a trader is not exposed to a potential bullish or bearish developing trend on a specific currency pair based on aggressive loose actions run by a central bank (e.g. ECB’s QE, or Fed cutting fed funds). By using this statistical ‘arbitrage’ strategy, a trader is exposed to three different countries, which helps to increase the diversification effect. There are several signals a trader could use to establish a strategy based on cointegration trading. First of all, he has to decide if the signal is going to be deterministic or ‘stochastic’. Then, he would have two moving bands:
1. when the spreads (or residuals) exceed the positive band (i.e. > 0.10), short the spread, and when the spreads go below the negative band (i.e. -0.15), long the spread.
2. When you long (resp. short) the spread, you are basically going long (resp. short) 1 unit EURUSD and short (resp. long) x unit of GBPUSD.