At the TRADING forum and its Charts of Note thread where I post my charts, I was asked the following .......
Deucy,
How do you calculate SL for these type of trades that continue to diverge. I assume you don't just keep adding layers.
The trading world within the context of the subject of "discipline" has the use of stops. I learned quickly with my my particular, self-made style of of pair trading as it evolved the first year I pair traded that stops were highly self destructive rather than self preserving. The reason that sounds insane to experienced traders is because, I think, the enormity of the trading world and its common theme of protective stops is appropriate wherever you look. However, in my style, rather than pre-determining a stop, instead I use a process of stopping.
Anyone uninterested in checking into the simplicity of pair trading, will find the following subject of "stops" tedious, I suppose. But pairs trading my style is fun and steady income with relatively less risk and less need for frequent use of stops. Those courting the notion of pair trading will get constructive insight from my addressing this specific subject of "stops" that will carry over in to an advantage trading pairs my style. I can't help but believe that "trying" will result in either extreme: ho-hum OR passionately willing to pursue it. Results will almost be immediate as my style comes with only a brief learning curve. I also believe there is an enormous population of non-traders that just want to move their portfolio into better returns than 2%, and with just a little effort can apply a degree of my style which is more investor friendly and less trader frenetic than conventional pair trading or any other style of trading I am aware of. Non-sexy investing with steady, respectable investment income without having to predict market direction that only requires a modest degree of being pro-active is how I describe my style. For greater returns, the investor could dial up to more frequent "trading" should the trading bug motivate.
My empirical evidence that pre-calculated stops don't work in my style of pairs trading which is swing trading in flavor is suggestive to me that this "hedging" of pairs is some kind of different animal to begin with. My style bakes in safety relative to other trading I know which innately calls for fewer needs of "stops." That is not true from what I know of conventional pairs trading that is more highly oriented to arithmetic and statistical arbitrage along with shorter times in trades and smaller tolerance to unbooked loss in the trade than for my style. Where others would be bailing out, I find that same degree of unbooked loss for me to be the approaching proximity of a threshold of explosive gains being a high probability OR frequently slower, steady, unbooked gains that start at the most recently installed layers and trickle down into earlier installed layers. I learned from my early years of pair trading my style that when I broke from adding layers, I quickly became disappointed. To reinforce my confidence of the trade before I make a decision in a multi-layered posture, I go back to studying what made me begin the trade. I also search for fundamentals of the companies that occurred while I was in the trade that were disfavorable to my position. (At other times I don't use fundamentals.) Generally, disfavorable fundamentals occurring while in the trade either individually or in the aggregate have to be very significant to move my needle toward closing a trade. They have to be impactful enough to compromise the "rubber band stretching" formation of the stock plots so significantly as to make me believe I could be carrying dead money for possibly eternity. Otherwise, I keep the faith in my position knowing from personal experience that a rubber band that snaps back is just as likely as entering a new, promising trade.
I am not against taking losses when I deem them to be for my best interest.
(1) In multi-layered trades, when justified, I will book gains on the most recent layers while closing out with a loss on the original first layer. But I will be very thoughtful before booking a loss on that original first layer, reviewing again why I got into the trade and the disfavorable fundamentals that occurred while in it. I also am mindful of how the plots behaved as they went against me, returned favorably to me, and the "rhythm" if any of how the position developed a profile for itself formed by the frequency with which there was oscillation moving away from gains and returning to gains. Sometimes this results in a net positive gain, sometimes in a net loss that is small relative to the aggregate loss territory I had found myself in before the plots turned favorable for me.
(2) The frequency of booking a loss occurs more often for me with just one layer or soon after installing a 2nd layer that is enjoying a relatively small gain or loss. In this scenario, I am driven to closing out the trade because after re-examination of cause for getting into the trade I determine either by objective analysis or instinct, I could do better and faster somewhere else. So here is an occasion where I am reviewing in depth why I got into the trade in the same manner as described earlier with multi-layered trades. There was something here that didn't suit me as well as when I started the trade. I may have made the decision to close out just before tactfully adding a second layer. Adding a second layer is done (adding more risk) when I have determined, yes, I will be closing out totally, but not before I take advantage of a rhythm the trade has expressed that allows me to be confident that the second layer will enjoy a degree of success. This will mitigate the net loss.
I have referred to oscillating rhythms of a pair that move my position toward gain and then to loss and then to repeat again and again. Happily this occurs essentially at the same limits in either direction. In all occasions and with all existing layers simultaneously, one can scalp this rhythm of predictability. It is pleasing that these incremental gains inside the longer trade objective of the pair can mitigate loss incurred from an eventual decision to close out with finality a pair trade. In some small way it can influence stopping all trade in the pair that appears to be too challenged to meet the longer term objective.
Reading the above by the unpracticed pair trader is academic but hopefully motivating. Experiencing it is empowering and confidence building. In the final analysis, I don't believe there is any organic advantage I had when I started pair trading that exceeded that possessed by anyone else. My results since beginning to pair trade my style are booked trades with gains easily over 80% of all trades I put on, and I am being conservative. Many losses experienced at specific layers of a pair are not much more than a typical gain at that level on winning pair trades. My more notorious losses number few and each wipe out approximately three times as much gain at those layers experienced from winning pair trades.
With the relative ease of hitting singles and doubles while experiencing the occasional triples and home runs all in the context of non-concern of market direction and no need for pre-calculated stops and their frequent frustrations, my style of pair trading tends to maintain stable, mental hygiene while having fun doing it. It lends itself very well to a more investing nature with the appropriate pairs if one is inclined to approach it that way rather than frequent trading.
Good trading and prosper !
