If you are using a value strategy, you would many times be getting long the weaker stock and shorting the higher multiple growth stock. As others have stated you are playing these types of pairs for a longer time frame, using larger distribution levels for layering and trying to capture as much noise as possible as the fundamentals come into line, which may take years, or never occur at all. For me, as long as there is enough noise or chop in the spread for me to trade I don't really care if the fundamentals come in or not. I just need a bias to lower the risk of getting caught in a buyout, and historically value has outperformed growth over the long term.
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Pair Trading Strategy Journal
- Thread starter jonnysharp
- Start date
Quote from total_keops:
If you read the book Statistical Arbitrage, [/B]
I have these books, about PairTrading:
* McGraw-Hill,.The Complete Arbitrage Deskbook
* Statistical Arbitrage
* The_Handbook_of_Pairs_Trading
* Trading Pairs Capturing Profits And Hedging Risk With Statistical Arbitrage Strategies
*Wiley Finance,.Pairs Trading - Quantitative Methods and Analysis
Anyone knows any other books devoted to pair-trading?
Thanks
Quote from jones247:
When pair trading two stocks (preferably within the same sector), there's a MAJOR PROBLEM with the mean-reversion strategy. The assumption is that the two stocks will converge after diverging to a certain point. Oftentimes, layering-in is used to improve the performance of the mean-reversion plan (i.e. "it did not revert on the 1st entry, let's try to enter again - hoping that the reversion will occur after the next std deviation).
This is the crux of the problem: If fundamentals dictate that you long the strong stock and short the weaker stock, then one would think that the stock is more likely to continue to diverge rather than converge. To bet on a mean-reversion, one would typically need to short the strong stock and long the weak stock. In doing so, it appears that you're betting against market fundamentals.
In a nutshell, my theory is that it may be better to trade with the trend of the divergence than to try and anticipate a reversal (mean reversion) of the two stocks. In other words, once a pair start to diverge (especially if supported by fundamentals such as earnings or news reports), then enter the spread with the plan of the divergence continuing.
Perhaps mean-reversion would be better suited with indicies, such as the spy vs. dia...
your thoughts... Do you see a problem with my logic???
There is no hard and fast rules for correct trading, every trader devises his own system and logic, there isn't a holy grail so your logic could be applied successfully to trade, however with what you said you could be long the strong stock and short the weak stock after they made a divergence(strong stock went down, weak stock went up) so you are on the right side of the fundamentals and still capture the convergence. I think your thinking more of long/short trading, where you trade the divergence, i.e.....buy a fundamentally strong stock on a upside breakout and short a fundamentally weak stock on a downside breakout. This strategy can work too, however as others stated is more medium/long term trading as opposed to capturing short and sharp moves with pair trading.
Quote from jonnysharp:
however with what you said you could be long the strong stock and short the weak stock after they made a divergence(strong stock went down, weak stock went up) so you are on the right side of the fundamentals and still capture the convergence. I think your thinking more of long/short trading, where you trade the divergence, i.e.....buy a fundamentally strong stock on a upside breakout and short a fundamentally weak stock on a downside breakout. This strategy can work too, however as others stated is more medium/long term trading as opposed to capturing short and sharp moves with pair trading.
Excellent points jonny... I guess my assumption was that very rarely would there be a divergence with the strong stock going down and the weak stock going up. If that were to happen, I would have to wonder if there is some event that I haven't learned about (i.e. merger/acquisition). Nonetheless, my aim would be to get in and out of all pair trades as soon as possible (preferably intraday trades with the spreads)...
Walt
Quote from jones247:
Excellent points jonny... I guess my assumption was that very rarely would there be a divergence with the strong stock going down and the weak stock going up. If that were to happen, I would have to wonder if there is some event that I haven't learned about (i.e. merger/acquisition). Nonetheless, my aim would be to get in and out of all pair trades as soon as possible (preferably intraday trades with the spreads)...
Walt
Just want to add one thing to Walts comments. There are two types of pairs. Ones that trend in a direction and the ones that dance up and down around a mean without really going in any direction.
MEan reversion will always occur, it just depends on your time frame. Johnny likes to swing trade and is willing to hold a long time...Hence his 100 day time frames. Others are intraday pair trading capturing the daily reversions. And others are pair trading to limit volitility yet capture a long term trend. An example might be long GLD short SPY.
I have three strategies I employ with pairs. One is a mean reversion strategy such as Johnny's, but I use RSI on individual stocks to help me make a decision that the reversion is actually happening. Another strategy I use is based on the volitilty of the pair ratio spread. The third which I am most compfortable with and is also the easiest to understand is looking at the pair ratio and applying simple moving average crossovers and cross unders for buy trade signals coupled with the pairs RSI. For example the 50 day moving average crosses up over the 200 day average...go long the pair and vice versa when it crosses under. Pretty simple concept huh? Ever do that with individual stocks?
THe third way is the easiest to uderstand because you don't really care about correlation or standard diviations etc. You can also use the the moving average lines for support and resistance levels. You are also not trying to pick the reversal.
Anyway, keep things simple and find something that works for you. Cheers.
Good luck.
Hi everyone.
Firstly thanks to jonny for starting this thread. I have been following with interest and have read the whole thread in recent days. Also, congratulations on your amazing results.
Yobo, keep up the good work also, I value your input to this thread.
I've been trading through mechanical systems for a few years now, and was wondering if anybody here trades a Pair Trading system similar to jonny's one?
If so, can you please send me a PM so we can discuss it there and not clog up jonny's thread.
I was reading an academic paper on Pairs Trading by a couple of guys from Yale the other day. Interestingly, according to them, stocks from different sectors didn't make much of a difference to returns. They tested their strategy from 1960s to 2002 and it showed significant outperformance of the S&P500, about double the excess return with third to half of the risk.
In addition, their strategy outperformed in bear and sideways markets (like the 70s) but underperformed during the recent 1990s bullmarket. Therefore, it would compliment my trendfollowing system rather nicely.
Attached is the article Im talking about.
But again, if you already trade a mechanical Pairs Trading system or are in the process of designing such a system, please let me know through PM.
Nizar.
Firstly thanks to jonny for starting this thread. I have been following with interest and have read the whole thread in recent days. Also, congratulations on your amazing results.
Yobo, keep up the good work also, I value your input to this thread.
I've been trading through mechanical systems for a few years now, and was wondering if anybody here trades a Pair Trading system similar to jonny's one?
If so, can you please send me a PM so we can discuss it there and not clog up jonny's thread.
I was reading an academic paper on Pairs Trading by a couple of guys from Yale the other day. Interestingly, according to them, stocks from different sectors didn't make much of a difference to returns. They tested their strategy from 1960s to 2002 and it showed significant outperformance of the S&P500, about double the excess return with third to half of the risk.
In addition, their strategy outperformed in bear and sideways markets (like the 70s) but underperformed during the recent 1990s bullmarket. Therefore, it would compliment my trendfollowing system rather nicely.
Attached is the article Im talking about.
But again, if you already trade a mechanical Pairs Trading system or are in the process of designing such a system, please let me know through PM.
Nizar.
Attachments
yobo
Your methods sound great!
Can you comment on your success using 1st vs 3rd method? Are any of them better performers in certain type of the markets?
Also, for the 3rd method given the choppiness of the markets did you experiment with shorter term averages, like 14 and 50? And to clarify, you go long (or short) BOTH stocks in the pair. How do you incorporate RSI. Are you seeing that RSI of the ratio is a heat beat and in 30-70 range? How do you choose the pair to begin with? Correlation/same sector? On average how long you hold the pair in last 4 months?
I'm sorry that I'm asking so many questions and not offering anything in return.... helpfully for now.
Your methods sound great!
Can you comment on your success using 1st vs 3rd method? Are any of them better performers in certain type of the markets?
Also, for the 3rd method given the choppiness of the markets did you experiment with shorter term averages, like 14 and 50? And to clarify, you go long (or short) BOTH stocks in the pair. How do you incorporate RSI. Are you seeing that RSI of the ratio is a heat beat and in 30-70 range? How do you choose the pair to begin with? Correlation/same sector? On average how long you hold the pair in last 4 months?
I'm sorry that I'm asking so many questions and not offering anything in return.... helpfully for now.