Equity Spread Trading Hedge Ratios

FastandFurious · Aug 10, 2009

When trading spreads such as MRK vs. PFE whose closing price is 30.10 and 15.96 respectively, do you do 1:2 to balance out the dollar amount?

rodmike9 · Aug 10, 2009

Volatility weighted would be a more accurate representation. Although, you don't want to deviate (no pun intended) too far from dollar-weighted.

Arnie · Aug 10, 2009

You may also want to weight the long side a little heavier in the current environment.

FastandFurious · Aug 10, 2009

I can see where volatility be a good play here. I can take the historical volatility of both and do a ratio.

However, if I just want to be dollar weighted and trade the volatility, it would be 1 MRK to 2 PFE no? On other spreads such as XOM-CVX, there is no doubling...why?

spreadem · Aug 10, 2009

Quote from FastandFurious:

When trading spreads such as MRK vs. PFE whose closing price is 30.10 and 15.96 respectively, do you do 1:2 to balance out the dollar amount?

This spread will cost you about $4600 per 100 shares at 1:1 ratio. If you initiated the trade at Friday's open you'd be up $160 or about 3.5% in two days. Not bad.

sjfan · Aug 10, 2009

Volatility weighting implicitly assumes a correlation of 100%. Do so at your own risk.

Quote from rodmike9:

Volatility weighted would be a more accurate representation. Although, you don't want to deviate (no pun intended) too far from dollar-weighted.

FastandFurious · Aug 10, 2009

Quote from spreadem:

This spread will cost you about $4600 per 100 shares at 1:1 ratio. If you initiated the trade at Friday's open you'd be up $160 or about 3.5% in two days. Not bad.

right, but my question is, do most people trade it 1:2 or 1:1? What are the benefits of each

sjfan · Aug 10, 2009

Both are guess works; It's impossible for one to always work better than the other. It all depends on the correlation between the pair.

Quote from FastandFurious:

right, but my question is, do most people trade it 1:2 or 1:1? What are the benefits of each

rodmike9 · Aug 10, 2009

Quote from sjfan:

Volatility weighting implicitly assumes a correlation of 100%. Do so at your own risk.

Actually, trading dollar-weighted would be an assumption of 100% correlation, whereas volatility-weighted would be an adjustment to compensate for the lack of correlation.

sjfan · Aug 10, 2009

Not True. For two stocks A and B

Hedging Ratio = Beta(A,B) = Cov(A,B)/Var(B)

Correlation = Cov(A,B)/Std(A)Std(B)

If Correlation = 1, then

Cov(A,B) = Std(A)Std(B)

Then, substitute this back into the hedging ratio calculation, you get

Beta(A,B) = Std(A)Std(B)/Var(B) = Std(A)/Std(B) Since Var(B) = Std(B)*Std(B).

So, under 100% correlation, the correlate hedging ratio is the volatility ratio.

The correct hedging ratio for 0% correction... is 0! If the pair isn't correlated, it's not a pair trade.

Quote from rodmike9:

Actually, trading dollar-weighted would be an assumption of 100% correlation, whereas volatility-weighted would be an adjustment to compensate for the lack of correlation.