Pairs Trading Strategy Model

There are dozens of guys/gals trading this pair..... many more who USED to trade it and either lost all their money or someone else's.

I know one guy who blew out his account at Bright on GE/HON (and quite a bit of the firm's money), then went to Generic and, I've heard, he blew out on FNM/FRE there. I also heard he was the Risk Manager at the local Generic office until they decided he needed to go.

I think the best strategy is to find a firm willing to let you gamble a lot of their money. If you blow out at the first firm, keep hopping around. Eventually, you are bound to make a mil by sheer luck! And....I'm not kidding about this.
 
I think that is like saying "trading stocks" got cold. There are
an infinite amount of ways/styles/strategies withing pairs
trading to say that it went "cold" is impossible.

However, my style went cold this fall. 23 months up in a row,
two months down. I attribute it to a temporary interday
correlation breakdown across more names than usual
(in particular the names I trade (liquid listed universe).

I absolutely believe with the comment on the other thread,
in general pairs trading can be a lower risk (albeit) lower
reward way to trade. But a slow steady rising p&L curve
is what most traders should try to achieve.
 
However, my style went cold this fall. 23 months up in a row,
two months down.

Markets change. Your universe of stocks change. decimalization has really hurt my trading. Program trading has hurt my trading. A lot of different factors have affected my performance trading pairs (including my own psyche). What I have had to do to stay in this business is to adapt to different styles of trading. I have forced myself to lower my expectations and to look to hit singles and not give up the home runs instead of swinging for the fences like I have the last 3 years.
good luck
 
I just found this site a few days ago, and have enjoyed reading the post and glad to see that ideas are being exchanged. I have a model that I am working on that I would like to share, and hopefully get some input with...

It starts with a matrix written by Bloomberg (those w/ access to bloomberg can email me for directions on how to get the matrix). The matrix allows you to input a list of stocks (max of 256--# of excel columns), or you can enter an index like SOX or NBI (Nasdaq biotech index), and the days back and it will retrieve the data for you...it does not do intraday. The spreadsheet produces 2 tabs, one with the matrix of each comparison/correlation...the second with a list of the two securies and thier correlation.

This just gives you the stocks and thier correlation...nothing more. I wrote a coniditional format for the matrix to paint stocks >95% correlation BLUE and <-50% RED. The second tab listing the pairs and correlations can be 'filtered' in excel to show the same data. Once the data is listed, you can then fill in a number of columns on current market data (% Change, Open, High, Low, etc) various fundamentals, relative strength, technical info (put/call ratios) etc.

Once you fill in the blanks, you can write conditional formats to show which one is 'better' than the comparison. IE-all you are looking to do is identify the stronger stock and the weaker stock, NOT forcasting direction!! For example....
With Bloomberg, I can pull in 1,2,5-day % change. The both may be up or down randomly over the period, but when I apply the conditional formats, and see that the 1,2,5 day % change is green (three greens in a row) I can see that it is outperforming its counterpart with 3 reds in a row. This is not rocket science, and it is not the ideal entry...but it has lead to fairly decent returns (-5% - my stop loss tollerance to 15% in a few days) ...and I never even looked at a chart or any fancy indicators. Granted, timing can likely be improved by looking at multiple regression analysis, normal distribution curves, Z-Scores, etc.

There are other excel 'add-ins' out there that will calculate the matrix for you. Check out www.factset.com or www.portfolioscience.com Esignal and others may have the same info now, I'm not sure. TradeStation or MetaStock may do them as well...if anyone knows, please let me know! The matrix is a quick and easy way to calculate correlations. Many people traded BRCD/QLGC for a long time, because they were very highly correlated, but due to QLGC's recent run-up, it may not behave the same way as BRCD, and their correlations have likely changed.

I have read about a lot here of people loosing a ton of money trading pairs, but the odds dramatically favor pair trading, as opposed to directional trading. Consider the following:

2 stocks, 2 outcomes (up or down/win or loss)

Pair Outcomes:
Stock A - Win
Stock A - Loss
Stock B- Win
Stock B- Loss
(win/loss NOT EQUAL to Long/short or Up/down)


Trade Outcomes:
Stock A- Win & B- Win (winning trade)
Stock A - Win & B - Loss (wash)
Stock A - Loss & B - Win (wash)
Stock A - Loss & B - Loss (loss)

The final results mean there are a 1/4 chance of winning, 1/4 chance of loosing, and 2/4 chances of the trade washing out...compared to the 50/50% chance of winning on a directional trade.

Just because you are 'hedged' through a pair, doesnt mean you can disregard common rules of trading....CUT LOSSES, use proven position sizing/pyrimiding money management techniques, etc.

The point is...I've demonstrated earlier how the risk/reward favors pairs over directional trading...When you're right, the profits can be componded because both long and short can work in your favor at the same time, but they can also work against you.

Good luck....
PearTrader
 
like one dude said before-it may work for some time.
it been work for some time for me (not the way you choose)
but, one day, after i left for 30 min to pick my son from school pair got from 3% to 20% in different directions. regular stocks, no news, just like finger snap..BUM! and since then-my winning system start been unprofitable at all. more than 300 winning trades over about 10-15 losses became totally useless.))))))
why do i say all this-because i do believe, there is not much difference between directional trading and pair trading.
sorry for may bad english. just my word of caution)))))))
 
I spoke above about cutting losses....

For those who use excel for their calculations, you can program a simple 'stop loss' that basically says

IF %ReturnSinceEntry is LessThanOrEqualTo - 5 %, THEN ......
....then make that cell RED (conditional format)
....then play a wave file that shouts "SELL, SELL, SELL"
etc (requires VisualBasic code)

Bloomberg's Tradebook ECN and other programs (possibly RealTick and TradeStation) can launch orders when certain excel conditions are met...

For example....
If ABC/XYZ < -5%, then Sell ABC @ Mkt AND Buy XYZ @ Mkt

There are probably other ways. The good thing about pairs, is that RARELY does a pair move so fast that you cant get out with more than 0.25% slippage, unless one gaps up or down....which brings up another point....

**EARNINGS DATES**...
Some programs allow a DDE link to excel to import the expected earnings date....
If you have todays date in a cell =today() and the earnigns date in another cell, then write a conditional format that says

IF (EarningsDate cell) is LessThan 5 WeekDays from today, THEN....
...then make that cell YELLOW....
If (EarningsDate cell) is LessThan 2 WeekDays from today, THEN....
....make that cell RED....

This will ensure you dont hold a stock through its earnings date, unless that is part of your strategy.
 
Quote from PearTrader:

**EARNINGS DATES**...
Some programs allow a DDE link to excel to import the expected earnings date....
More...

Good idea. Does anyone know a way to import an earnings date into excel automatically through DDE? Perhaps you can download the earnings date through Yahoo finance the way some download EOD quotes?

Dividend dates might be useful as well.

:cool:
 
Quote from PearTrader:

I spoke above about cutting losses....

For those who use excel for their calculations, you can program a simple 'stop loss' that basically says

IF %ReturnSinceEntry is LessThanOrEqualTo - 5 %, THEN ......
....then make that cell RED (conditional format)
....then play a wave file that shouts "SELL, SELL, SELL"
etc (requires VisualBasic code)

Bloomberg's Tradebook ECN and other programs (possibly RealTick and TradeStation) can launch orders when certain excel conditions are met...

For example....
If ABC/XYZ < -5%, then Sell ABC @ Mkt AND Buy XYZ @ Mkt

There are probably other ways. The good thing about pairs, is that RARELY does a pair move so fast that you cant get out with more than 0.25% slippage, unless one gaps up or down....which brings up another point....

**EARNINGS DATES**...
Some programs allow a DDE link to excel to import the expected earnings date....
If you have todays date in a cell =today() and the earnigns date in another cell, then write a conditional format that says

IF (EarningsDate cell) is LessThan 5 WeekDays from today, THEN....
...then make that cell YELLOW....
If (EarningsDate cell) is LessThan 2 WeekDays from today, THEN....
....make that cell RED....

This will ensure you dont hold a stock through its earnings date, unless that is part of your strategy.
More...

PearTrader,

All this stuff and your previous post is "arithmetic" to a professional pair trader, i.e., it is elementary.

I am not trying to dissuade you from doing pairs - I did it successfully for a while. But I can tell you in no uncertain terms that something about the market changed that made this kind of trading very difficult [disclaimer - as I usually say, this is more a statement about _me_ than anything else.] If you like, the risk holding period changed in such a way as to make it leave the bounds of my risk tolerance...If I reduced the holding period, the chances of stopping out were much greater [than they used to be]

I have not given up on it. I have some new key insights that I am still working on, but I am not holding my breath...

nitro
 
Quote from nitro:



PearTrader,

All this stuff and your previous post is "arithmetic" to a professional pair trader, i.e., it is elementary.

I am not trying to dissuade you from doing pairs - I did it successfully for a while. But I can tell you in no uncertain terms that something about the market changed that made this kind of trading very difficult [disclaimer - as I usually say, this is more a statement about _me_ than anything else.] If you like, the risk holding period changed in such a way as to make it leave the bounds of my risk tolerance...If I reduced the holding period, the chances of stopping out were much greater [than they used to be]

I have not given up on it. I have some new key insights that I am still working on, but I am not holding my breath...

nitro
More...


nitro-dig into volume... one of the keys-there...

mrDinky-how many pairs you planning to trade, if you need automate alert on them? a thousands? i trade few stocks, they make about 15-20 pairs. you must know everything about them. from products to behavior in different market conditions.
i don't know what you mean, on export earnings thru DDE))))but, you can create web query in excel and it will raise alert. need a little VBA knowledge
 
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