Pairs Trading Strategy Model

DaveN · Sep 16, 2002

Originally posted by Neutral_Al
The ratio is 0.8244 at 14:22 today. AGN is a much better hedge/pair for MRK. The correlation over the past 2years is much higher. If you still want to trade MRK/LLY, I would suggest to wait for R=.8 or lower.

Neutral_Al,

I'm just curious: Are you calculating your correlations from daily bars or some lower resolution?

I suppose this goes back to the basic premise of pairs trading. Some traders will want to look for pairs that are correlated, or revert to mean, on longer timeframes such as by end of day, and others will want pairs that might trade faster, i.e. correlated better on hourly bars. Certainly, correlation on these smaller timeframes does reduce the size of the average trade you'd expect.

Does anyone have any pairs experience that would say, "use daily correlation as this produces better intraday moves" or instead "use shorter timeframes for correlation to get the most tradeable pairs."

Thanks in advance for any insights!

ChrisM · Sep 16, 2002

Originally posted by Neutral_Al
I have been lately introduced to pairs trading. It sound like it is a great strategy to trade uncertain bear market in a trading range. I am looking for resources to learn more and develop my own strategy/model. Please help!

Thanks

Anytime I hear a new name of old thing (spread trading in this case) I wonder how long it will exist.
There are correlations. It`s nothing new. But very few of them are reliable. Even fewer of them make any money.

balda · Sep 16, 2002

I've been watching this site for past two months. Following their recommendations I would be up 22K on 500k account but I don't have 500K account

good luck.

metooxx · Sep 16, 2002

Originally posted by balda
I've been watching this site for past two months. Following their recommendations I would be up 22K on 500k account but I don't have 500K account

good luck.

That is always a problem ...

Neutral_Al · Sep 16, 2002

Originally posted by ChrisM

Anytime I hear a new name of old thing (spread trading in this case) I wonder how long it will exist.
There are correlations. It`s nothing new. But very few of them are reliable. Even fewer of them make any money.

ChrisM,
You are right, most of the correlations do not always work. What I am trying to do is to find a pair of stocks where the price ratio predictably oscillates around a certain moving average. I calculate 2 year correlation which tells me that if this pair of stocks behaved the same way for 2 years, there is a high probability it would revert to mean again. I do not plan to trade correlation, I just use it to increase the probability of a profitable trade.
As for making money, it is very much possible. If hedge funds make money trading pairs and PairsTrading.com people make money, so can I.

Al

WDGann · Sep 16, 2002

I am very new to Pairs Trading, even though I have been trading the conventional way.

I have a few questions:
After you get the correlation factors, do you look at the fundamentals of the correlations of how they relate? Do you look at each individual stocks after to gain more edge? Is the identifying criterias similar to options and the designated product?

Also, is there a book out about this? I'm completely new to this and regardless of actual trading the strategy, I'd like to keep the topic in my shelves.

Mark Conway · Sep 16, 2002

Originally posted by WDGann
I am very new to Pairs Trading, even though I have been trading the conventional way.

I have a few questions:
After you get the correlation factors, do you look at the fundamentals of the correlations of how they relate? Do you look at each individual stocks after to gain more edge? Is the identifying criterias similar to options and the designated product?

Also, is there a book out about this? I'm completely new to this and regardless of actual trading the strategy, I'd like to keep the topic in my shelves.

There are two books that I know of with pair trading chapters. The first book (of which I am author) is Professional Stock Trading (ISBN: 0971853649); this covers intraday pair trading and is based on volatility hedging, e.g., using Tharp's Percent Volatility Model to equalize position size. The other book is The Complete Arbitrage Deskbook by Stephan Reverre, which covers multi-day spreads.

Avaturk · Sep 17, 2002

Mark-

I enjoyed your article in TASM. I found the information very useful, especially how you used volatility. Thank you for your straightforward presentation of the subject. I was able to build a trading system based on your ideas (and a few of my own) which has proven to be my most robust system over the past few months.

For those of you thinking about spread trading based on correlation, how you treat volatility in your trade selection and execution is fundamental. If you treat spread trading as a linear distribution of data, you will likely lose money. Picking out stocks to spread and looking at a simple ratio is only part of the process.
Would suggest reading Mark's article or some of the other books referenced here with a keen eye as to how volatility is treated.

ChrisM · Sep 17, 2002

Neutral_Al ,

You are right about that. The only problem is that You never know when this correlation stops working. Many of them live for 2-3 years period, some much longer.

H2O · Sep 17, 2002

The solution to this is very simple but efficient.
Take a look at www.2hedge.com

The 3rd screen from te TBonds TNotes spread shows a screen on which you can set your trading parameters. On the right side you see (only half) your trade limit / stop.

This means : the software takes into calculation it only enters a trade when current correlation is above xxx or does get you out of your trade when correlation drops below xxx.

Hope this helps