Pairs Trading Strategy Model

Quote from esc_trader:



LTCM did not fail because their assumptions/model was flawed.
They had on too much leverage to be able to withstand the positions going way too far in the wrong direction. The correlations eventually revert back, as the model says that it will, but before that happens, it goes so far the other way you get ruined in the process.

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Well ... all processes revert to some mean after enough time. Not everybody can wait for 10^30 years to observe "average" behaviour.

LTCM failed IMHO because they were arrogant people who started believing their own press. They clearly failed in what should be the very first item any firm in this busuiness invests in: a compliance system that does not allow anyone to violate the risk model and reports to senior management each and every day - or even hourly or more if the risk parameters go outside of the comfort zone - with the total risk exposure of the firm.
 
Cal

i agree. LTCM was human failure not so much a modelling weakness. nevertheless most people who quote on LTCM do that without proper understanding. the leverage is one issue of that kind. yes, they used way too much leverage, but still you can use more leverage in curve trades on us governments than you should use on eminies. so when people use the LTCM case in order to tell that fixed income arbitrage as such uses too much leverage - that is hard to swallow. nobody mentioned that here, but i heard that on many discussions since 1998 and i sometimes hear it before it is said.

the portfolio as such was sound. it was too big, but it was sound and suffered a four sigma event or even more. LTCM should have survived this with a 20% draw down if they had not been the kind of personalities they had been and pushed the engine too far.

we looked at LTCM in early 1998 beause it was a very popular fund at that time but we decided we could not invest, because they would not tell anything about what they were doing. thus one could not check if they had any kind of real risk process.


peace
 
LTCM failed because they began to make more directional bets, abandoning the cautious hedging strategy that had been its trademark. With spreads shrinking in bond arbitrage due to other copycat firms, LTCM was desperate to park its capital someplace else. The fund started dabbling in equity derivatives and other fields where it didn't have expertise or an edge. Combined with huge leverage and the hubris of its partners, LTCM was poised for disaster. The reason LTCM had phenomenal growth during its first few years was because bond arbitrage was still a fairly new field, and the partners in the fund were the founding fathers in this arena while at Salomon.
 
They were, and if I recall correctly from Lowenstien's book, it was the only part of the fund that was still profitable when they finally broke it up. The book said they were big in RD-SC, among others.

Quote from man:

ltcm did no equity pairstrading as far as i know.
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Don't forget Merton and Scholes also started telling their investors the "actual" odds of LTCM losing 5%, 10%, etc... as if they were rolling a pair of dice. If that doesn't send up a four-alarm signal, I don't know what does.

Lescor's right, according to Lowenstein, LTCM did pair trade. They had about 10x what Goldman had in RD/SC. They got involved in M&A deals too.

:cool:
 
time to get out of the markets. when trading i get so chopped up that i feel like a cat in a chinese neighborhood.
the specialists are all scum just look at FNM FRE. the fnm guy will spread the stock 30 cents wide keeps on dropping it and then none of your bids get filled when trying to buy and then when you try to buy the offer stock goes up 30-50 cents
protest by not trading anf giving these scumbags your money
 
Well , Statistically all PRICES SHOULD REVERT TO MEAN but this is a long term strategy ( as all statistical strategies work most effective in long term ) not suitable for intra day traders.. In fact this assumptions is dangerous..
Lets say STOCK X is trading @ its mean . i.e. Intra day VWAP ... Now DOW rallies pulling stock X up more than 2 SD away from its VWAP .. So STOCKX is a good candidate for shorting as statistically there is 95 % chance of STOCK X reversion to it's intra day VWAP
The problem is if you take a short position you are going against the general market trend TRYING TO CALL THE TOP (TOO RISKY ) .. Alternatively you can have a strategy to Long those stocks that deviate from their mean fast and furious.. The logic behind this strategy is :
IF STOCK IS STRONG ENOUGH TO DEVIATE 2SD FROM ITS VWAP FAST ENOUGH THEN I WILL BACK THE STRENGTH ON THE FIRST PULL BACK..

I have been back testing both strategies i.e shorting or Longing those stocks which deviate 2sd from their mean and this is my conclusion :--

Most statistical approaches donot work intra _day and a trader is far better off to back the strength ( Go long when deviation exceeds 2sd) than short and go against the trend.

Hope this helps
 
Quote from iraj:

Well , Statistically all PRICES SHOULD REVERT TO MEAN but this is a long term strategy ( as all statistical strategies work most effective in long term ) not suitable for intra day traders.. In fact this assumptions is dangerous..
Lets say STOCK X is trading @ its mean . i.e. Intra day VWAP ... Now DOW rallies pulling stock X up more than 2 SD away from its VWAP .. So STOCKX is a good candidate for shorting as statistically there is 95 % chance of STOCK X reversion to it's intra day VWAP
The problem is if you take a short position you are going against the general market trend TRYING TO CALL THE TOP (TOO RISKY ) .. Alternatively you can have a strategy to Long those stocks that deviate from their mean fast and furious.. The logic behind this strategy is :
IF STOCK IS STRONG ENOUGH TO DEVIATE 2SD FROM ITS VWAP FAST ENOUGH THEN I WILL BACK THE STRENGTH ON THE FIRST PULL BACK..

I have been back testing both strategies i.e shorting or Longing those stocks which deviate 2sd from their mean and this is my conclusion :--

Most statistical approaches donot work intra _day and a trader is far better off to back the strength ( Go long when deviation exceeds 2sd) than short and go against the trend.

Hope this helps
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I also back tested both strategies (not intraday though).
Here is my conclusion: Pairs obviously do not always reverse to mean.
I also do not consider 2SD to be enough to decide if one stock is overbought (oversold) compared to another. On my opinion, RSI is much better in this case. So, for the pair to be a candidate, it should have AT LEAST 2SD plus RSI.
Even these pairs do reverse approximately 3 or 4 times out of 5.
Those times when they do not reverse, eventually, of course, they will, but at that time MEAN would be obviously slightly different.
More interesting question – is it possible to predict in advance, will the pair reverse or diverse if it has 2SD and RSI is at extreme levels? My back testing shows that it is possible. So, I trade both strategies. Even more interesting that winners/losers ratio about the same in both cases (3-4 to 1). And I also had 2 months out of 8 this year when result was negative
 
quote from m&m&m:
More interesting question – is it possible to predict in advance, will the pair reverse or diverse if it has 2SD and RSI is at extreme levels? My back testing shows that it is possible. So, I trade both strategies. Even more interesting that winners/losers ratio about the same in both cases (3-4 to 1). And I also had 2 months out of 8 this year when result was negative
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m&m&m,
How many pairs do you follow/trade? Care to provide any insight on what characteristics you look for to determine prediction of divergence vs. reversion for a particular pair? Your win/loss ratio is excellent. :cool:
 
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