Pair Trading Strategy Journal

Quote from Treve1:

For me the system is working this way:
In May I made 34 trades. I closed 20 trades for a profit and only three for a loss. One would think this is a great achievement, but it is not since I am still keeping 11 pairs and most of them are awful. The worst pair is PTI � short and BLKB- long. Alone PTI I am currently 47% in minus, this is by far too much. Good thing I am taking only small positions, but still this doesn't save me.

I am sure that most of the 11 pairs I will sell for a loss and should I sell them now I would wipe out all of the profit I already made with the 20 profitable trades. Actually I would be in a big minus assuming I sold all the 34 trades as for today. But I am waiting for exit signals......

Successful Trading means: Cut Your Losses and Let Your Profits Run, but the strategy is doing the exact opposite. I have the impression that I am cutting the winner and I let the losses run. I am happy with the exit signals, but sometimes I could sell half of the position, protect myself with the stop loss and try to make more money.
More important however, is cutting the loosing trades. It does make sense to be long the smaller stock since the majority of my losing trades are the trades I went short.
Secondly, it will be necessary to observe the news for all the pairs. This would take some time but it would pay off. Does anyone know what news would be the most important to check? What are the best websites to check for news quickly and efficiently? Any other suggestions? Does anyone experience similar problems?

Last week seem not to be good for mean reversion.
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Treve,

Keep your head up. Yea, last week was pretty awful for me also. I have one pair that has eaten into my profits, to the extent of around 20% of the position size (CEPH/VRX).

However I don't yet have enough trades to make any significant statements, and I'm not going to start 'tweaking' with things like 'only buy the small market cap' and other fundamentals. If it turns out after 100 trades that I suck at picking pairs, or that the last 20 were just as sucky as the first 80 (meaning I'm not learning how to dentify a good ratio chart or other stuff), then I'll jump out and re-evaluate.

Not sure if this helps, other than everyone goes through slumps. I think Jonny talked about a drawdown of 8-10% of his portfolio of open and closed equity in the process of his journal, so unless you have stepped beyond that boundary, your still well within his trading range.

Adrian
 
Quote from tradingtrading:

Dr Who, thank you for your response. I confess that I am impressed by your results and that you are inding significant numbers of UK trades to monitor. What kind of stocks are you looking at?
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FTSE 100 and 250. Just look at pairs in similar sectors. You can get the details from here : http://www.londonstockexchange.com/...gger/indexsector.htm?bsg=true&in=1191732.FTSE

I'm a little less concerned about very high correlation than some but I need them to backtest well with a very high proportion of winners and high Avg WT/LT ratio.
 
When you guys do some backtesting like that, do you take care of taking out the period from september to november 2008 because it was an abnormaly inneficient period for pairs or you just assume that this is representative of the expectations you can have about the future? This period had many good opportunities because a lot of unloading was happening I think and this is not very representative of normal market conditions.
 
I feel it's critical to research of fundmentals. You need to put in the effort.....

Often you get a massive divergence from a historical correlating pair.. It looks like the perfect setup through PTF and "ENTER" will be flashing all over the place.

All it takes is a little effort to realise there is a massive change in the underlying fundamentals and you'll soon realise some "great trades" are actually suicidal

Sometimes it's the trades you don't take not the ones you do, that prove the difference





Quote from cipherscribe:

Treve,

Keep your head up. Yea, last week was pretty awful for me also. I have one pair that has eaten into my profits, to the extent of around 20% of the position size (CEPH/VRX).

However I don't yet have enough trades to make any significant statements, and I'm not going to start 'tweaking' with things like 'only buy the small market cap' and other fundamentals. If it turns out after 100 trades that I suck at picking pairs, or that the last 20 were just as sucky as the first 80 (meaning I'm not learning how to dentify a good ratio chart or other stuff), then I'll jump out and re-evaluate.

Not sure if this helps, other than everyone goes through slumps. I think Jonny talked about a drawdown of 8-10% of his portfolio of open and closed equity in the process of his journal, so unless you have stepped beyond that boundary, your still well within his trading range.

Adrian
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:cool: :cool:
 
Quote from bentedges:

Hedge funds CAN and DO use this strategy, typically with a longer time frame than seconds,minutes,hours,or days.

The reasons are many for why stocks diverge, but it is my opinion the major reason is because the vast majority of money is ran by mutual funds, who are long-only. Their buying and selling creates opportunities versus a much smaller lot of folks that play in the stat arb space.

I think what johhnysharp may have been speaking of are funds like Renaissance Capital, the large hedge fund founded and ran by James Simons. They are known to run their lightening-quick algorithms to capture pennies in hundreds of stocks throughout the day.
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some thoughts from a quant trader on the advantages of mean-reversion strategies vs momentum. don't know about doubling the position, though, sounds too risky.


epchan.blogspot.com/2007/08/perils-of-momentum-strategies.html


" . . . when more and more traders decide to adopt mean-reverting strategies, all they do is to eliminate the trading opportunity. The market becomes efficient, and nobody makes any money, but nobody loses either. [emphasis added - VG]

In contrast, when more and more traders decide to adopt momentum strategies, the momentum will be established sooner and sooner. For e.g. in the case of event-driven strategies which are mostly momentum-based, the new equilibrium price will have been established almost instantaneously after the event is publicly disclosed. Under this circumstance, any momentum trades that are entered just a little bit late will not only suffer zero profit, but will likely suffer losses as mean-reversion almost inevitably takes over. But how soon do we need to enter in order to avoid this fate? (It can't be too soon either because often a trend need to be established first in order to trigger an entry signal.) It is unfortunately a moving target as competition increases: 1 day earlier might work now, but may not be sufficient a few months from now. (The exit trade also suffers the same problem, as we don't know how long the momentum will last.) It is a dangerous game to play.

Indeed, time is often a friend of the mean-reversion trader: the longer s/he waits, perhaps the more profitable the trading opportunity. And if s/he enters too early and suffers a loss, s/he can always double the position. As I explained in a previous article, stop-loss should generally not be applied to mean-reverting trades on a short time-scale. [emphasis added - VG]

So even if the trader does not double-up the position, an eventual re-couping of the loss is more than likely. On the other hand, time is an enemy of the momentum trader: if s/he loses the first-mover advantage and suffers heavy loss, I argued in that article that a stop-loss is advised, and thus the loss is forever locked-in.
 
Quote from Ms Varima-Garch:


Indeed, time is often a friend of the mean-reversion trader: the longer s/he waits, perhaps the more profitable the trading opportunity. And if s/he enters too early and suffers a loss, s/he can always double the position. As I explained in a previous article, stop-loss should generally not be applied to mean-reverting trades on a short time-scale. [emphasis added - VG]
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I believe the pairs trading he refers to in his articles are with commodity ETFs. In these pairs the underlying fundamentals haven't changed, because the pricing of the commodities within the ETFs is the same. Therefore the price relationship is not a reflection of an underlying fundamental change.

Within the stock pairs that tend to be traded on here, it is by no means clear that there hasn't been a change in fundamentals. Therefore doubling up on a losing trade could lead to ruin a lot quicker than you think. Particularly, if the pricing anamoly is due to insider trading or other participants trading on non-publicly available information. The last point is little discussed, but I believe it is a real danger to the pairs trader.
 
Quote from tradingtrading:

I believe the pairs trading he refers to in his articles are with commodity ETFs. In these pairs the underlying fundamentals haven't changed, because the pricing of the commodities within the ETFs is the same. Therefore the price relationship is not a reflection of an underlying fundamental change.

Within the stock pairs that tend to be traded on here, it is by no means clear that there hasn't been a change in fundamentals. Therefore doubling up on a losing trade could lead to ruin a lot quicker than you think. Particularly, if the pricing anamoly is due to insider trading or other participants trading on non-publicly available information. The last point is little discussed, but I believe it is a real danger to the pairs trader.
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well, if you take, say, GLD vs GDX, the gold producers etf, gld is a pure play on the price of gold.

and GDX is a play on the prospects of the gold mining industry.

the price of gold may be going up, but GDX price may be fluctuating around the gold trend, based on market perception (accurate or inaccurate, exaggerated or underestimated).

this may be the market's estimate of costs of production in the industry, so gold may be going up, but the cost of production may kill some of that price windfall, for the companies.

gold experts probably know better, but i think there must be some rule of thumb ratios (or at least ranges, based on historical performance of gold vs the producer) that are used.

i guess what i'm saying is there are probably fundamental factors at play here too, GLD vs GDX, USO vs XLE, XOM vs XLE etc.

if the cost of production really is too high vs some mean metrics, then maybe there's a fundamental reason for producer to be not good vs gold

but if it's blown out of proportion, then, i guess, you just take it from there. . .

Varima
 
Quote from cipherscribe:

Hi Angelo.

Cointegration is when prices move together over a period of time, at approximately the same rate, thus avoiding exploding spreads, and profitable circumstances for cointegration pairs traders.

Is that right?

Adrian
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Well, to the best of my understanding and starting with this link I've already cited in my previous post..

http://epchan.com/downloads/cointegration.pdf


Stock A and Stock C are said to be cointegrated because and when

one can build a “derivative” of their historical price series (a derivative isn’t necessarily a complicated thing: in Chan’s example is simply formed by the two stocks’ prices differences: “price of A- price of C”) which has the following properties:

• its mean is constant (no upward or downward slope) …. that means is not changing with the passing of time (that’s my understanding of Chan claiming “the spread in stock prices between A & C always return to a 1 after a while”);
• its standard deviation is also a constant, and that’s means the two prices do diverge but not in a measure too different from what has happened in the past.


So, you can see how is neither crucial for two cointegrated stocks to move together… nor desirable…. as only when the Spread (A-C) is diverging from its mean you can bet on a mean reverting process…calculating when is unlikely the present divergence would still widen by a significant amount (consant STD DEV).

Of course, this would be a perfect world… and we all know perfection also exist in theory.


Not using financial series, my best example of a cointegrated couple: think about two lovers who often argue about where to spend the week-end: A would like to go the beach, C would like to go to the mountains.
Most of the time they depart together on Saturdays for the same destination after reaching a temporary agreement; sometimes they are not in agreement and spend the week end split.
But, as there is true love (=they are cointegrated) they all come back to the same home on Sunday evenings.


PS I've tried to answer in plain English (I'm not a quant!!!); if you like some technical jargon.... look some thread at Willmott, for example

http://www.wilmott.com/messageview.cfm?catid=19&threadid=17690
 
PFE/WYE, 300X100. WYE long, dividend due on 06/08. Sell on 06/05.

KO/PEP, 100X100. KO long, dividend due on 06/11. Sell on 06/10.

Both pairs are $ neutral.
 
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