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Notes
Currency Consistency: Ensure tickers are in the same currency to avoid exchange rate noise affecting the ratio.
Beta Correlation: Ensure the beta (calculated from montly periodic returns) is significant. Otherwise, you may be trading noise, and there will be no reliable reversal to the mean.
Recommendation: Always check the seasonality plot of the ticker you intend to swing trade; ensure the historical seasonality isn't moving against your position.
Beta Analysis Summary for Ratio Trading
To ensure a ratio trade is based on structural correlation rather than random price movement, the Beta (calculated via monthly periodic returns) must be significant. A low Beta indicates that Asset A and Asset B are "decoupled," meaning any apparent pattern in the ratio is likely statistical noise with no mathematical pressure to return to the mean. Conversely, a high Beta confirms the assets are "tethered," making mean-reversion strategies reliable.
Statistical Warning: The Beta Validity Test
The following table defines the boundaries between random noise and actionable correlation based on monthly Beta coefficients:
EXTREME CAUTION.
The assets are decoupled. No statistical reason for the ratio to return to the mean.
Assets with Beta's in this range can be used for diversifying portfolios.
CAUTION.
Significant risk of "drift" where the ratio diverges permanently from historical averages.
Assets with Beta's in this range provide little value for both diversification and mean reversion trading.
OPTIMAL.
Assets are tethered. High probability of mean reversion when the ratio stretches.
Assets with Beta's in this range are ideal for mean reversion trading. However, be cautious of very high beta's (e.g., >2) which indicate high volatility assets.
*Note 1: CAUTION! It is possible for the Beta of a ratio to be a negative value. This indicates an inverse relationship between the assets. So when one asset goes up the other tends to go down.
This is often used for hedging strategies.
*Note 2: RatioPlotter.eu uses periodic returns (relative changes) to ensure the Beta reflects the structural relationship regardless of the absolute currency price of the assets.
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