Relative Value Directional Model
A hybrid strategy that uses statistical divergence to initiate a single-legged momentum trade.
1Divergence as a Signal
This strategy uses extreme statistical divergence (high Z-score on the price ratio) as a signal that the pair's relationship is under stress. It is a directional trade, not a market-neutral one.
Core Premise:
When the ratio's Z-score crosses the entry threshold (e.g., Z > 2.5), one stock has moved significantly, and the other is expected to follow (momentum) or lag behind (laggard).
⚠️ Key Difference:
This model is NOT market-neutral. It opens a directional position on one stock, betting on the direction of market momentum.
2Driver Attribution (Max Change Logic)
When the Z-score indicates divergence, the model performs an attribution analysis over the period that caused the divergence to identify the market driver.
Logic:
The stock with the highest absolute percentage price change between the start of the divergence and the entry point is identified as the Driver.
🎯 Dynamic Target Setting:
The absolute percentage move of this Driver stock is used to set the profit target for the trade, ensuring the target scales with the volatility of the signal.
3Trading the Follower
The trade is executed exclusively on the Follower (Laggard) stock, betting that it will move in the same direction as the Driver to restore equilibrium or chase the market momentum.
📈 Divergence: Ratio is High
If Stock A drove the divergence: LONG Stock B.
If Stock B drove the divergence: SHORT Stock A.
📉 Divergence: Ratio is Low
If Stock A drove the divergence: SHORT Stock B.
If Stock B drove the divergence: LONG Stock A.
🎯 Dynamic Sizing:
Position sizing is determined by setting the capital based on the single stock traded, not a beta-hedged pair.
4Dynamic Exit Strategy
This model utilizes both the ratio's Z-score and statistical properties to define dynamic, self-adjusting exit points.
Target Profit:
The trade is closed when the profit equals the Max Absolute % Change of the Driver, captured at the moment of entry.
Statistical Time Stop:
The trade is forcibly closed after Half-Life / 2 days (Half-Life divided by two), limiting capital exposure if convergence fails.
5Advantages and Risks
This model offers higher return potential than traditional pairs trading but carries directional risk.
✅ Advantages:
- Capitalizes on pure momentum and lag effects
- Dynamic exits adjust to market volatility
- Simpler position sizing (single leg)
⚠️ Risks:
- Exposed to overall market risk (not market-neutral)
- Vulnerable if the Follower stock fails to move
- Requires accurate attribution logic
Ready to Test the Directional Edge?
Use the Pair Analyzer to identify which stock is the Driver and test this strategy in the dedicated backtest module.
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💡 Pro Tip
Since this is a directional strategy, ensure the market is in a strong trend environment to maximize the probability of the follower stock catching up.