Pairs Trading Strategy Model

[thetraderprofit]

I know I said I was finished on this forum, but I just had to get this in:

Bob 111, your problem is NOT pair trading. It's children. Stop picking up your kid during trading. Has he ever heard of a school bus?
Taxi? Bike? Rickshaw?


Here's the advice I gave all new traders when I ran a Bright office:
Ditch the kids. They represent the biggest drawdown you'll ever have in your life. Join Big Brothers. At least they become someone else's problem when you are trading.

 

[Bob111]

 

[vikana]

Quote from nitro:

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

Exactly my findings, too. There is very little left to trade on that I've been able to identify.

 

[PearTrader]

Quote from nitro:



peartrader,

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


I realize that this is elementary...I realize that not everyone is a 'professional' trader...I also realize that this has worked for me for quite some time.

I don't have all the answers...if anyone here does, please speak up! I was simply tying to offer some thoughts to those who are looking for answers.

You are right...cutting losses systematically is 'elementary' ...but why then are so many of the post here about people losing money and blowing up?

Because their system changed?? Because the market changed?? Possibly. Understandable too....markets are dynamic, and the industry is dynamic. One of the hardest lessons to learn about trading a pair is that you can't trade it like a stock...meaning that the chart of a pair can't be read like a single-stock chart.

Some argue that pair trading ONLY works in side-ways markets...that is true ONLY if your system tries to identify support and resistance between an oscillating ratio. This could be why many systems have lost money....because in the past 9 weeks, we have had a bit of a rally (some stocks have performed very well during this rally, while others have remained stagnate QLGC/BRCD is a great example that used to oscillate between a ratio that doesn't exist any more)...prior to that we were in a definitive downtrend. The same people would also argue why would anyone trade a pair in a bull or bear market...when you could just go long or short and not suffer the loss of the hedge?? It just depends on your system...and your ability to forecast trend changes.

Statistical models I believe work best, in most any market....here is why:

Consider a ratio that moves along up or down randomly. That price channel is contained in some measurable pattern (use 2 standard deviations for example)...up, down, sideways whatever...

Then all the sudden something unusual happens....the ratio is outside the norm. Several things can happen that can correct the situation: 1) The long can move 2) the short can move 3)They can both move such that they are now back inside the range. Those who try to 'leg-into' the pair are likely missing half (or all) of the move. If your bias toward the trend of the pair is upward, and you buy the long when the ratio is out of whack, legging into the pair with the intention of shorting when prices are more favorable, you could easily miss the short move that causes the RATIO to come BACK INTO WHACK.

Good luck,
PT

 

[Neutral_Al]

I got an e-mail from www.pairstrading.com over the weekend stating that they lounched a new pairs trading software product on their site. I subscribed today for the first time. The software gave me 33 pairs for the Russel 1000. Some of them look pretty interesting. Some are really strange.
Has anyone else seen this new product?
Let me know your thoughts...

Al

 

[Homer]

What is the holding period for these pairs?? hours, days, weeks, months?? I have a feeling that the russell spreads have a long holding period which exposes you to a LOT of risk imo. I have traded many longer term pairs but I prefer the shorter term quick profits (quick & nimble in this market). I have also signed on for a free trial to the website and have been very unimpressed with the pairs that they have recommmended

 

[Neutral_Al]

Quote from Homer:

What is the holding period for these pairs?? hours, days, weeks, months?? I have a feeling that the russell spreads have a long holding period which exposes you to a LOT of risk imo. I have traded many longer term pairs but I prefer the shorter term quick profits (quick & nimble in this market). I have also signed on for a free trial to the website and have been very unimpressed with the pairs that they have recommended

Hi Homer,

Apparently what they did was they took certain correlation and divergence parameters and calculated all the pairs for the Russell for the past 10 years. According to them, any pair has a probability of 80% to revert back to mean within 2 months. I guess if you trade all the pairs that they give you and hold them for 2 months, then you should win 80% of the time. The problem is twofold: a) you cannot trade all the pairs, and b) they don't give you exit points (profit or stop loss). So you have to do a lot of research yourself. I would not blindly trade these pairs...
On the other hand, this software could be helpful as a research tool. They do give you correlated pairs and they do calculate the most highly correlated stocks with the stock of your choice. That is pretty cool. All you have to do now is some FA and TA to determine the most tradeable pair.

Al

 

[Homer]

Quote from Neutral_Al:



According to them, any pair has a probability of 80% to revert back to mean within 2 months. I guess if you trade all the pairs that they give you and hold them for 2 months, then you should win 80% of the time. The problem is twofold: a) you cannot trade all the pairs, and b) they don't give you exit points (profit or stop loss). So you have to do a lot of research yourself. I would not blindly trade these pairs...

Al,
I think mean reversion is the backbone to profitable pairtrading...in a volatile more liquid market. I don't think that it is the best call in this market however. It could work with the russell spreads (i've never traded russell pairs) but I am skeptical. What would most likely happen is that you will take your winners off earlier than you should and ride your loser a little longer than you should. And when you are talking about months holding period you are exposing yourself to a lot of risk, more risk than I can tolerate in this market. If you are disciplined enough to trade a variety of spreads and willing to wait for losers to either revert or stop yourself out I'm sure you could make decent money. I for one don't have the patience for that style of trading in this market. Do you have one or two examples of their picks (like a illiquid spread that you wouldn't trade but something that looks good)? also have you found any websites that can chart pairs easily (besides qcharts, which I use but am not a big fan)?
Homer

 

[Neutral_Al]

Quote from Homer:

Quote from Neutral_Al:



I think mean reversion is the backbone to profitable pairtrading...in a volatile more liquid market. I don't think that it is the best call in this market however. It could work with the russell spreads (i've never traded russell pairs) but I am skeptical. What would most likely happen is that you will take your winners off earlier than you should and ride your loser a little longer than you should. And when you are talking about months holding period you are exposing yourself to a lot of risk, more risk than I can tolerate in this market. If you are disciplined enough to trade a variety of spreads and willing to wait for losers to either revert or stop yourself out I'm sure you could make decent money. I for one don't have the patience for that style of trading in this market. Do you have one or two examples of their picks (like a illiquid spread that you wouldn't trade but something that looks good)? also have you found any websites that can chart pairs easily (besides qcharts, which I use but am not a big fan)?
Homer

Homer,
I just briefly scanned it again. One of the pairs that showed up is CECO/APOL. I do have a position in this pair already. It was one of the recommendation by PairsTrading.com. The only diffirence is that I waited a bit for 14dRSI to get overbout before jumping in. Another pair that looks OK techically is LMT/NLY. I know, aerospace and mortgages usually do not go together. But they are correlated at 86%. Technically the pair looks like it is approaching an intermediate support at R=2.75. My profit would be R=3.0 and Stop Loss @ R=2.6 or two weeks whatever comes first.
I also use Qcharts. There is no other charting service that lets you plott ratios and do adequate TA, as far as I know.

Al

 

[mjb]

Be carefull. Any correlation between such difference stocks could be (and probably is) a fluke that will not continue in the future. secondly, where did you get that correlation measure? i show that there r-squared is .3 using prices and .05 (noise) using percent changes on the day. bloomberg screen attached.