For those with an Unfair Advantage subscription, we can continue our study using the Unfair Advantage Correlation Chart.  Open Unfair Advantage, and click on the menu button for the Correlation Chart.



This opens the "Correlation Chart Preferences Dialog":

The first and second market and amount of history are all the same as from the website.  The remaining Settings are system parameters which will be explained later.  The Visible Lines check boxes allow you to control which system lines are displayed.  Displaying all of the lines at once is too confusing.  The Individual Market Z-scores are the blue and red lines from the website.  The Signal Line which may be green or gray is the same as the website.  The Channel Lines shows the relevant recent range of the Signal Line as used by the Correlation Channel Breakout System.  The system's entry and exit prices may be displayed allong with the simulated equity curve.

The remaining preference "Walk Forward Computations" is important.  On the website, all calculations are "Full Period" rather than "Walk Forward".  "Full Period" calculations give you the clearest view of the current situation, but do not reflect how historical situations would have been seen at the time.  For example, the correlation between a pair of markets varies over time.  A pair which is strongly positively correlated today may not have been strongly correlated at some points in past.  The pair may even have some historical periods where they were negatively correlated.  As a result, a "Full Period" chart will show a green Signal Line since the markets are positively correlated from our current perspective, but a "Walk Forward" chart may show segments of green and gray Signal Lines with gaps.  Since we are interested in correlations which reflect underlying economic relationships, we are not interested in trading during time periods where the correlation is not fairly strong and consistent.

Once you press OK, you get a Correlation Chart:

This chart should look familiar since it has the same lines as the website correlation chart.  One thing which may confuse you is that the red and blue may be reversed.  On the website, the requested pair are sometimes reversed to get the red for sell and blue for buy coloring.  This is very handy for assessing the current situation, but is not helpful when analyzing the history where the markets criss-cross over each other.  The Correlation Chart within Unfair Advantage always has the first market in red and the second market in blue.  This can be seen in the legend in the lower left. " Z-Score HO " is red; because, HO was the first system entered.

The Correlation Channel Breakout System uses a look-back period of 25 days (Enter Period and Exit Period) to determine the range of values the Signal Line currently occupies.  This is used to judge the likely times to enter and exit a trade.  For example, in 2004, we have two potential big trades.  One worked out, the other didn't.
To see how this works, press the Properties button on the chart itself:

Then check "Channel Lines"

and press OK.  The Channel Lines are sometimes spotty and sometimes strong:

Spotty

Strong

Spottiness happens when the markets are criss-crossing each other (a sign of market efficiency), or because the correlation coefficient is waffling around at a low level.  When the Channel Lines are spotty, we want to avoid trading the system.  To help us, we have two settings:


The "Min Z to Enter" preference tells the system to ignore entry signals when the the Signal Line is below some threshold.  Judging an appropriate threshold will be discussed later, but 1.6 is a reasonable place to start.  The "Min Correlation" preference tells the system to ignore entry signals when the correlation drops below a threshold.  In this case, the threshold is 70%.  The system will only simulate a trade when the correlation is greater than +70% or less than -70%.  70% is a reasonable number, but some people require as much as 90% before they are willing to risk their money.  The important thing is for the correlation coefficient to be consistent over time as saw on the website:

88% is a bit lower than the other time periods, but this is, overall, a modest amount of variation.

We have discussed the Channel Lines, what makes them sometimes spotty, and how to avoid trading during spottiness.  This leaves us clear to discuss what to do when the Channel Lines are strong.  Back in 2004, we have two strong swings out of alignment for these markets.

Creation: For some reason, the markets get mis-priced relative to their historical relationship. Plateau: The economic basis for the relationships pulls the markets to an intermediate state where they are moving in tandem again, but with an unusual spread in their prices.  Realignment: The markets begin to move back together.  The Correlation Channel Breakout System makes its entry trade when the Channel Line is crossed.  This happens when the Signal Line retreats back to a prior level.  The sensitivity is controled by the "Entry Period" preference for the system. Correction: Once the economic basis has regained its control and brought the markets back in line, the final swing back to the zero-line often happens quickly.  Sometimes the Signal Line continues trending, sometime it seems to bounce off the zero line, and sometimes it just seems to hover near zero.  In any of these cases, the Correlation Channel Breakout System closes the trade when the Signal Line reaches the "Exit at Z-Score" preference.

Creation: The prices get mispriced for some reason. Plateau: The economic basis of the relationship creates a plateau of resistenace at some point. Realignment: The markets begin to move back together.  In this case, the markets jumped back to new highs before finally heading down. Correction: The Signal Line does eventually make it back to zero, but not before it retests the high again.

In the two trades in 2004, both made a profit eventually.  The first trade had little volatility while the profits flowed in while the second trade would have scared most traders as the trade took us into much deep open-equity loses then our expected final profit.  There are two things we do to try to avoid these high volatility trades.  The first thing is to avoid trading when the Signal Line isn't very large.  The "Min Z to Enter" value of 1.6 would have kept us out of this trade since the value was down to 1.4 when the Channel Line was touched.  By choosing large values, we have more statistically significant mispricing.  These should be more confident trades, but fewer to pick from.

The second thing that we do to avoid high volatility trades is to employ a stop-loss using the other Channel Line.  If the Signal Line is below the zero line, then we are using the recent high for our entry signal, and we can use the recent low for our stop-loss signal.  This does not guarantee us that we will only lose exactly that much, but it gives us an objective measure of how much risk we are taking with the trade and an objective point to say that the correlation is still in the Creation stage and has not Plateaued yet.  By default, both of the Channel Lines are based on a 25 day window.  You can control each of the window sizes separately using the "Enter Period " and "Exit Period" preferences.  Some people prefer to use a longer "Enter Period" and a shorter "Exit Period" . 

Profitable trades end by Signal Line retracing to the zero level (shown in black.)  The exact exit level is chosen by the "Exit at Z-Score" preference.  Here we have used a value of 0.1.  Since the actual trade is executed at the next open, it doesn't have to be too precise, but if you make it too small, the Signal Line can jump back into a new trade without you taking your profit.

Now that we have the Correlation Channel Breakout System described, we can take a look at the results.  If we click on the Properties button again, we can add the Entries and Exits:

These appear as Red or Green arrows to show the entry trade, and a Yellow arrow to show the exit.

The remaining visible line option allow us to see the System Equity Line.  The System Equity Line shows the Hypothetical Account Balance for this backtesting simulation.

Now that we have covered all of the preferences and displays with the Correlation Channel Breakout System, we can take a look at the System Performance Analysis Statistics.

Right-Click on the chart and choose "View System Performance Statistics". 

This will provide you with detailed and general statistics.

For example, you can see the details of each trade:

And all of the system performance statistics you would expected:

We have learn alot from this example about how to use the software, and we have learned that the spread between a finished good and its raw material can have tradable misalignments. When the supply chain is disrupted, extraordinary losses/profits can result from this type of relationship.