85Introduction
In Chapter 5, we explained that strategy design was essentially a three-step
process. The three steps are identification of stock pairs, cointegration test-
ing, and trading rule formulation. In this chapter, we focus on the first of the
three steps, the process of identifying potential stock pairs. In this step we es-
sentially short-list the pairs for cointegration testing and further analysis.
Why do we need to do that? We could just as well work with a candidate list
of all possible pairs, run cointegration tests on all of them, and eliminate
pairs that fail the tests. This certainly seems reasonable, except for the fact
that in a universe of 5,000 stocks, we have a total of about 12 million pairs.
CHAPTER
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