Pairs Trading Strategy Model

Hi All,

I have put together an informational web site on pairs trading. On the site, daily, is posted one or more equity pairs that is currently in an identifiable trading channel. Todays post is a pair of bank stocks.

However, the real gem of the site is the "Pair Finder" tool. Sign up for the free trail and and tell me what you think. Goto: http://www.pairfinder.com/ to check it out.

Thanks Royce:)
 
Looks like a nice site. Similar to www.pairstrading.com. I like that "The Pair Finder" allows you to select the analysis period and filter out stocks with low volume, market cap, and price.

Incidentally, there's another site, www.pairsfinder.com, that I accidentally went to. It's under construction. Will be interesting to see if it has anything to do with investments.
 
I see many people discuss correlations and some choose to use price while others focus on returns.

I use returns due to an argument that I have referred to as the "law of one price" which simply suggests that comparable assets with comparable risk/reward characteristics (2 companies in the same industry, for example) should return the same reward. As a result, a $10,000 investment in 2 oil drillers cannot have hugely divergent returns else there would be an arbitrage.

Those that focus on prices would say that a $10 and a $50 stock that both went up and down by $1 over a time series would be perfectly correlated despite the fact that the returns our grossly different.

Anyway what do you other pairs/stat arb guys do?

Also, how do you set up your hedge / position ratios? I like beta neutral positions where I compute the beta of my long versus a single unit of my short.

Looking forward to your thoughts.
 
I think any references to price in this thread are just for simplicity sake. Most pairs traders are actually looking at the ratio of stock prices. So with a 10% increase in price on stock A, all other things being equal, we would expect a 10% in stock B. The www.pairfinder.com site does base their analytics on offsetting betas as you indicated. My question is, how much of a difference does this make? If your pair is two major banks, for example, is their difference in betas that significant? If so, I might question whether they are good pairs to start with.
 
I disagree that most traders trade ratios (C divided by JPM) versus differentials (C minus JPM -- with a multiplier factored in to the differential -- Like (C*.7) - (JPM *1)).

Differentials by far better reflect the real risk of a spread in true price changes versus percentage changes.

I'm a professional pair trader doing this for a living. Know your risks.

Surely you can trade pairs via ratios but for new traders you'll find differentials to be easier to understand and define risk. Ratio's may be for more long term PROFESSIONAL pair swingers or investors, but even then you can get lost in the apparent lask of risk in a ratio chart. Look at the losses the pairstrading.com guy has been taking lately. He trades ratios and for the life of me I don't see where he defines his risk.

Seems to me some ratio traders assign the same capital size to each pair via ratio analysis, but when you look at the differentials you can clearly see that some pairs are far more risky than others and therefore you'd trade smaller size on these pairs. Varied bet size is critical.

Just something to think about. More info found at www.pairtrader.com and others.
 
sslaven,

Since you obviously have experience in this area, let me pose a few questions to you. I've been learning on the fly so to speak but would like to compare notes.

1) What sort of holding period do you typically experience for a trade?

2) When your trade is going against you, do you typically take your losses at a set point, hang on and wait it out, or increase your position size? This assumes there isn't a fundamental reason for the pairs relationship to change.

3) Do you normally trade based on convergence or divergence?

Thanks.
 
Sure...I'll give it my best shot.

1 &2) I'm a prop trader with Bright Trading. My comish is less than .75c/sh. What I do many can't simply because their costs are higher. Comish is definitely an issue in any strategy, but especially pairs since you have the long and short to put on and off.

I scalp all day long. I have defined biases, defined ranges that I want to play in, and defined risks on every trade. I do not suggest the "building into a position route till your account is on the brink of destruction - method". I do add 2 legs to almost everything. Lately, it's hard to make money without having 2 legs when you're scalping for 30-50c all day long.

Some of my account is dedicated for swings. Those last 2-3 days. More people are going this route lately since intraday ranges are so poor or trendy.

I hold positions when I know there isn't news on the pair. If it's not business as usual, I bail when trouble sets in.

I trade 5-10 pairs at a time. This helps too. Always something going on. Lately, I've been cruching more -- leaning on one side and only putting on the other if I have to. But each day is different.

3) I normally fade moves. Trading trends in pairs is tough if all you've done is fade for years (which I have). It's easier with anticorrelated pairs to trade the trend. I fade into support and resistance. I fade on quick retracements into a bias. I do my best to space out the distances between legs when they trend. You have to know the bigger picture -- as you can get blurry eyed in a shorter 2-3 minute time frame.

Hope that helps a bit.
 
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