Do i do a long/long or short/short of the trading pair when they have a negative cointegration coefficient?

External question — Quantitative Finance Stack Exchange Author: pbk Original post: https://quant.stackexchange.com/questions/80421 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. A pair of stock that I have been trading has a negative cointegration coefficient (Beta) that is statistically significant. When i want to long a spread, according to the spread equation below, I should long both stockA and stockB (vice versa for short spread). This pair has strong positive correlations that is statistically significant as well. The spread is stationary and hurst exponent is < 0.5. Backtest shows the strategy is profitable and I traded it live once by longing the spread (long Stock A and long stock B) and was profitable on both legs in the pair, similar to what i see in the backtest. However, this deviates from the market neutrality principle of pair trading when you typical do a long/short combo for a pair of stock. Am i doing the right thing by following the spread equation? Spread = StockA - Beta*StockB = StockA - (-0.8)*StockB

External answer — Quantitative Finance Stack Exchange Author: MrLCh Original post: https://quant.stackexchange.com/a/80439 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. In general it seems like what you are doing is reasonable to trade the negative cointegration. The extreme example would be thinking about trading a short etf against another etf. The cointegration could be negative and it would make sense in this scenario to go long both components. (As the one component is shorting the market). Coming back to your case: There could be a large tail risk in trading this strategy. Maybe the cointegration explains the normal behavior quite well, but the behavior could deviate massively in extreme events. During a market crash typically all stocks tend to suffer and being long both stocks would increase your risk (although there may be stocks that profit from a harsh downturn and still move against the market).