Trading systems come in two flavors: model-based and data-mining. This article deals with model based strategies. Cointegration based pairs trading forex significant market inefficiency gives a system only a relatively small edge. Any little mistake can turn a winning strategy into a losing one.
Developing a model-based strategy begins with the market inefficiency that you want to exploit. The inefficiency produces a price anomaly or price pattern that you can describe with a qualitative or quantitative model. The higher the predictive f term in relation to the nonpredictive ε term, the better is the strategy. Trading by throwing a coin loses the transaction costs. Not all price anomalies can be exploited.