# How to Create Kalman Filter in Python – Part VII

Articles From: QuantInsti
Website: QuantInsti

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In the final installment of this series, Rekhit Pachanekar demonstrates how to code in Python to create a sample pairs trading script. See Part IPart II , Part III,  Part IVPart V and Part VI of this series for details on the statistical terms and concepts used for creating Kalman Filter.

In pairs trading strategy we buy one stock and sell the other stock choosing the quantity as hedge ratio.

# Use the observed values of the price to get a rolling mean and z_score
mean, cov = kf.filter(ratio.values)
data[‘mean’] = mean.squeeze()
data[‘cov’] = cov.squeeze()
data[‘std’] = np.sqrt(data[‘cov’])
data = data.dropna()

data[‘ma’] = data[‘ratio’].rolling(5).mean()
data[‘z_score’] = (data[‘ma’] – data[‘mean’])/data[‘std’]

# Initialise positions as zero
data[‘position_1’] = np.nan
data[‘position_2’] = np.nan

# Generate buy, sell and square off signals as: z<-1 buy, z>1 sell and -1 for i in range (data.shape[0]):
if data[‘z_score’].iloc[i] < -1:
data[‘position_1’].iloc[i] = 1
data[‘position_2’].iloc[i] = -round(data[‘ratio’].iloc[i],0)
if data[‘z_score’].iloc[i] > 1:
data[‘position_1’].iloc[i] = -1
data[‘position_2’].iloc[i] = round(data[‘ratio’].iloc[i],0)
if (abs(data[‘z_score’].iloc[i]) < 1) & (abs(data['z_score'].iloc[i]) > 0):
data[‘position_1’].iloc[i] = 0
data[‘position_2’].iloc[i] = 0

# Calculate returns
data[‘returns’] = ((data[‘BAJAJ’]-data[‘BAJAJ’].shift(1))/data[‘BAJAJ’].shift(1))*data[‘position_1’].shift(1)+ ((data[‘HERO’]-data[‘HERO’].shift(1))/data
[‘HERO’].shift(1))*data[‘position_2’].shift(1)
data[‘returns’].sum()

The output is: 0.12282433836398741

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