Correlation Breakdown Mean Reversion

Entry Logic

• Long Entry: Two normally highly correlated assets diverge significantly. Buy the underperformer.
• Short Entry: Two normally highly correlated assets diverge significantly. Short the overperformer.
• Confirmation: The spread between the two assets begins to narrow.
• Timeframe: 60-minute.
• Location: Extreme divergence in a correlated pair.
• Market Condition: Any.

Exit Logic

• Profit Target: The spread reverts to its mean.
• Scaling Out: No.
• Trailing Stop: No.
• Signal Failure: Exit if the divergence continues.
• Opposite Signal: Not applicable.
• Time Expiration: 1-2 days.
• Momentum Loss: Exit if the reversion stalls.

Stop Loss Structure

• Hard Stop: A pre-defined maximum spread width.
• Soft Stop: If the correlation does not start to resume.
• Max Dollar Loss: $1500.
• Max Percent Loss: 3%.
• Structural Stop: Not applicable.

Risk Management Framework

• Risk Per Trade: 1.5%.
• Daily Limit: Not applicable.
• Weekly Limit: 6%.
• Max Drawdown: 18%.
• R:R Requirement: 2:1.

Position Sizing Model

• Sizing Approach: Dollar-neutral pairs.
• Volatility Adjustment: No.
• Conviction Sizing: No.
• Scaling In: No.
• Scaling Out: No.

Trade Filtering

• Market Conditions: Best when the breakdown is not caused by a major fundamental event.
• Setups: Requires a clear, historical correlation.
• Instruments: Any pair of highly correlated assets (e.g., Gold and Silver, AUD/USD and NZD/USD).
• Time Restrictions: None.
• Chop/News Avoidance: Be aware of news that could be affecting one asset more than the other.

Context Framework

• Trend Direction: Not applicable.
• VWAP Relationship: Not applicable.
• MA Relationship: Not applicable.
• Range Location: At an extreme of the spread's range.
• Higher TF Alignment: The daily chart should confirm the long-term correlation.

Trade Management Rules

• Breakeven: No.
• Scale Out: No.
• Add Size: No.
• Fast vs Slow Moves: Works for both.

Time Rules

• Optimal Window: Any.
• Times to Avoid: Around major news for either asset.
• Session Notes: A statistical arbitrage strategy.

Setup Classification

• A+ Setup: A 3 standard deviation breakdown in a very stable, long-term correlation.
• A Setup: A 2 standard deviation breakdown.
• B Setup: A 1.5 standard deviation breakdown.
• C Setup: A minor divergence.

Market Selection Criteria

• Instruments: Pairs with a correlation coefficient > 0.9.
• Volume: High.
• Volatility: Similar.

Statistical Edge Metrics

• Win Rate: 70%.
• Avg Win: 2R.
• Avg Loss: 1R.
• Profit Factor: 2.1.
• Expectancy: +0.7R.

Failure Conditions

• Market Conditions: A permanent change in the relationship between the two assets.
• Specific Scenarios: A country leaving a currency union, a company being acquired, etc.

Psychological Rules

• Discipline: Must trust the statistical relationship and be willing to hold the position for a day or two.

Advanced Components

• Regime Detection: Use a rolling correlation window to spot when the relationship is starting to break down.
• Filters: Avoid pairs where one asset is much more volatile than the other.
• Correlation: The entire strategy is based on this concept.
• MTF Alignment: Not applicable.

Location

• Strongest: In markets where historical relationships are stable.
• Weakest: In times of crisis or paradigm shifts.