My question comes from this paper, which is a short version of Avellaneda's paper The picture bellow provides a summary of the equations.
Do I understand correctly that in order to trade OU process I need to:
Run an OLS on two stocks (presumably cointegrated) with a lookback of 60 days
Calculate the auxiliary process X(k). (2.5)
Run AR(1) model on (2.5) series. (2.6)
Estimate OU parameters, and calculate the s-score which is -m/sigma since last X(k) = 0
Now steps 1-4 are in sample, but how do I proceed with the out of sample period? From the Chen's paper I understand that I would hold B0 and B1 constant and estimate next 5 days residuals, for each of those days I would repeat steps 2,3,4,5. Is it correct?
Previously I tried calculating S-score for every day running steps 1-4, but this approach is not profitable and generates random returns. I also tried holding the OLS beta constant for some time and calculate S-scores based on the residuals obtain with those constants, but with this approach beta becomes > 1 and equilibrium standard deviation is a square root of a negative number. All this was using actual prices instead of returns. If I use daily returns, results get random. Could someone please help?