Selecting Pairs for Pair Trading

[Agustingeolf]

I've just begun to trade pairs using a mean reversion system and am looking for a mathematically sound way of judging the correlation of prospective pairs without getting, at this stage, pulled too deep into rocket science (no doubt that'll come later). Which is more reliable -- correlation of historic prices or of historic price changes? The tests I have carried out produce very different results. All help welcome.

[Airbladefhp]

Well...PMCC? That's simple correlation.

Pearson product-moment correlation coefficient - Wikipedia, the free encyclopedia (http://en.wikipedia.org/wiki/PMCC)

Should give you everything you could possibly want to calculate it.

Your second question doesnt really make sense IMO.

Surely the most reliable would be the one with the best correlation?

[Airbladekaf]

Thanks, Hotch. I shall check out that link straightaway. Perhaps I didn't phrase the earlier posting clearly enough. What I meant was whether a correlation of the daily percentage change of two securities over a set period was a more reliable indicator of their suitability than a correlation of the historic prices during that same period. Again, thanks for the help.

[Airbladeueb]

Nothing wrong with your explanation, my fault, I'm wrapped up in my system and not on the right wave length.

Personally, I think change would be best. Not sure how to word my argument for it.