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Checklist, in Backtesting & Validation

Pairs Trading Validation Checklist

Pairs trading lives or dies on whether the spread actually reverts and keeps reverting. Correlation is not enough; the statistical relationship must be stationary and stable. This checklist validates a candidate pair before any capital is committed.

12 items. Published May 26, 2026. By AI Fin Hub Research.

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Sections

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Section 1

Phase 1: Relationship validity

3 items

Use the Pair Trading Cointegration Tester: Paste two price series. Engle-Granger cointegration test: OLS hedge ratio, Augmented Dickey-Fuller on residuals, Ornstein-Uhlenbeck half-life, z-score.

Section 2

Phase 2: Reversion dynamics

3 items

Use the Cointegration Half-Life Solver: Engle-Granger residual ADF + Ornstein-Uhlenbeck half-life from any two price/return series. Hedge ratio, p-value, spread chart. Browser-only.

Section 3

Phase 3: Spurious-pair defense

3 items

Use the Backtest Overfitting Score: Upload a backtest trade log and compute Probability of Backtest Overfitting (PBO), Deflated Sharpe Ratio, and the odds your edge survives live trading.

Use the Walk-Forward Validator: Upload a returns CSV. Rolling or expanding IS/OOS windows, per-window Sharpe, walk-forward efficiency, and a concatenated OOS equity curve. Catches regime.

Section 4

Phase 4: Tradeability

3 items

Use the Statistical Arbitrage Capacity Calculator: Maximum strategy AUM from alpha, slippage, fees, daily volume and volatility, and signal half-life. Square-root impact closed-form.

Use the Execution Simulator: Estimate execution cost in closed form — square-root permanent impact, linear temporary impact, half-spread, and a latency-drift band. See the slippage a naive backtest hides.

Tips

Small moves that make the checklist easier to finish

Correlation tells you two series moved together; cointegration tells you the spread comes back. Only the second one is tradeable, and confusing them is the classic pairs-trading mistake.
The half-life is your holding period and your risk clock at once. A reversion that takes months exposes you to the regime change that breaks the relationship before it pays.
When you mine a universe for pairs, you are running thousands of trials. The best-looking spread is partly luck, so the out-of-sample test is not optional, it is the whole proof.

Sources

  1. Co-integration and Error Correction: Representation, Estimation, and Testing , Engle, Granger, Econometrica (1987)
  2. Pairs Trading: Performance of a Relative-Value Arbitrage Rule , Gatev, Goetzmann, Rouwenhorst, Review of Financial Studies (2006)

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