Discussing the article: "Statistical Arbitrage Through Cointegrated Stocks (Part 10): Detecting Structural Breaks"
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Check out the new article: Statistical Arbitrage Through Cointegrated Stocks (Part 10): Detecting Structural Breaks.
This article presents the Chow test for detecting structural breaks in pair relationships and the application of the Cumulative Sum of Squares - CUSUM - for structural breaks monitoring and early detection. The article uses the Nvidia/Intel partnership announcement and the US Gov foreign trade tariff announcement as examples of slope inversion and intercept shift, respectively. Python scripts for all the tests are provided.
While researching the topic of cointegration, we are often exposed to a recurrent analogy: a drunk man walking his dog on a leash. They may move away sometimes, the man may walk in a tortuous way, the dog may jump faster and come back to the man, but they stay connected, tied by the leash. Eventually, they arrive home together. But what if, for any reason, the leash is broken?
Cointegration is a long-term relationship. The spread fluctuates constantly, but as we adjust the portfolio weights, we can stay in the business trading the same pair or basket for a relatively long time. Even a pair tied by simple correlation may sustain the correlation for a relatively long time, as long as we keep correcting the spread between them. Anyway, be it a correlation or a cointegration relationship, no relationship is forever. We know that at some point, it starts losing power, the pairs or assets in the basket start drifting away, the hedges start making no economic sense for trading, eventually leading to the removal of the pair or basket from our portfolio.
Usually, this process is a progressive one. It can be monitored and detected by the tools we have been using so far, like the rolling window eigenvector comparison (RWEC) and the in-sample/out-of-sample ADF (IS/OOS ADF). In the last article of this series, we saw how we can backtest the portfolio weights updates based on the live trading monitoring of these progressive deviations from the model.
However, sometimes the connection between the assets breaks in an unexpected way. The leash that once connected the man and the dog snapped. Not progressively, but suddenly. Not step-by-step in a couple of days or weeks, but as a single event in time, a breakpoint.
Author: Jocimar Lopes