Pairs Trading Strategy Model
- Thread starter Neutral_Al
- Start date
Did you know pairs trading is indirectly related to Jeff Bezos?
The Shaw referred to below is founder of D.E. Shaw, a massive quantitative arbitrage hedge fund. Jeff Bezos helped get it off the ground before he embarked on the Amazon.com project.
The more I learn about who is running with the world's money, the more intimidating trading becomes. This your competition with pairs strategies....
In 1986, Shaw was hired into the Analytical Proprietary Trading group at Morgan Stanley. This was a top-secret, "black-box" operation that worked behind a guarded door on the nineteenth floor of the Exxon building in midtown Manhattan. They were trying to exploit anomalies in stock market prices. Their job--aided by Shaw's computational expertise--was to isolate recurring patterns in financial data and use them to beat the market. The group was run by Nunzio Tartaglia, a former Jesuit seminarian with a Ph.D. in astrophysics, and Bill Cook, who was head of information technology at Morgan Stanley. It was Cook who later founded Tech Partners and tried to lure Norman Packard to Wall Street in 1991.
The secret being exploited at Morgan Stanley was something called pairs trading. Pairs trading traces its lineage back to Jesse Livermore, the famous speculator whose life story is recounted in Reminiscences of a Stock Operator, first published in 1923. Pairs trading is based on the idea that prices of related stocks should be correlated. Ford and General Motors will tend to fluctuate in price around the same news events. But what if an unusual gap develops, where Ford lags in price and GM pushes ahead of their normal relationship?
In this case, a stock speculator might go short, or sell, GM and go long, or buy, Ford. The market can crash. The market can soar. But if the gap between the two stocks remains unchanged, our speculator will neither win nor lose money. Such strategies are called market neutral. The bet is being placed not on which direction the stock market will move, but on company-specific or sector-specific correlations. If the gap between GM and Ford narrows, with GM falling and Ford rising in price, as predicted, our speculator will make money. How much money? One can only guess, but if Morgan Stanley was hiring astrophysicists and tracking additional 0s onto the salaries of college professors, the strategy must have been rewarding.
A key trick to statistical arbitrage, or stat arb, as Wall Street refers to pairs trading and other forms of algorithmic hedging, is to get one's strategy truly market neutral, not only to fluctuations in the stock market, but also to fluctuations in interest rates, foreign exchange movements, and global economic risks that can come at you faster than a shark going for red meat. Wall Street is filled with former employees of "market-neutral" h edge funds that went belly up because they weren't neutral enough.
Shaw worked for a year and a half at Morgan Stanley before striking out on his own. He wanted to expand pairs trading to include multiple classes of securities--bonds versus stocks versus options--and multiple markets hedged against one another in a computer network designed to be global market neutral. Shaw was going to stat arb the world; he was going to hedge the universe. Today, his computers are so powerful that Shaw, along with locating market inefficiencies, also detects rigged markets and other forms of cheating.
The Predictors pp. 106-107
The Shaw referred to below is founder of D.E. Shaw, a massive quantitative arbitrage hedge fund. Jeff Bezos helped get it off the ground before he embarked on the Amazon.com project.
The more I learn about who is running with the world's money, the more intimidating trading becomes. This your competition with pairs strategies....
In 1986, Shaw was hired into the Analytical Proprietary Trading group at Morgan Stanley. This was a top-secret, "black-box" operation that worked behind a guarded door on the nineteenth floor of the Exxon building in midtown Manhattan. They were trying to exploit anomalies in stock market prices. Their job--aided by Shaw's computational expertise--was to isolate recurring patterns in financial data and use them to beat the market. The group was run by Nunzio Tartaglia, a former Jesuit seminarian with a Ph.D. in astrophysics, and Bill Cook, who was head of information technology at Morgan Stanley. It was Cook who later founded Tech Partners and tried to lure Norman Packard to Wall Street in 1991.
The secret being exploited at Morgan Stanley was something called pairs trading. Pairs trading traces its lineage back to Jesse Livermore, the famous speculator whose life story is recounted in Reminiscences of a Stock Operator, first published in 1923. Pairs trading is based on the idea that prices of related stocks should be correlated. Ford and General Motors will tend to fluctuate in price around the same news events. But what if an unusual gap develops, where Ford lags in price and GM pushes ahead of their normal relationship?
In this case, a stock speculator might go short, or sell, GM and go long, or buy, Ford. The market can crash. The market can soar. But if the gap between the two stocks remains unchanged, our speculator will neither win nor lose money. Such strategies are called market neutral. The bet is being placed not on which direction the stock market will move, but on company-specific or sector-specific correlations. If the gap between GM and Ford narrows, with GM falling and Ford rising in price, as predicted, our speculator will make money. How much money? One can only guess, but if Morgan Stanley was hiring astrophysicists and tracking additional 0s onto the salaries of college professors, the strategy must have been rewarding.
A key trick to statistical arbitrage, or stat arb, as Wall Street refers to pairs trading and other forms of algorithmic hedging, is to get one's strategy truly market neutral, not only to fluctuations in the stock market, but also to fluctuations in interest rates, foreign exchange movements, and global economic risks that can come at you faster than a shark going for red meat. Wall Street is filled with former employees of "market-neutral" h edge funds that went belly up because they weren't neutral enough.
Shaw worked for a year and a half at Morgan Stanley before striking out on his own. He wanted to expand pairs trading to include multiple classes of securities--bonds versus stocks versus options--and multiple markets hedged against one another in a computer network designed to be global market neutral. Shaw was going to stat arb the world; he was going to hedge the universe. Today, his computers are so powerful that Shaw, along with locating market inefficiencies, also detects rigged markets and other forms of cheating.
The Predictors pp. 106-107
Bigbeech, mergers arb is normally known as risk arb, I think quant arb and stat arb are pretty interchangeable terms.
Mac
Mac
Just read the entire thread, pretty interesting and only have a few things to add.
First off, I can't imagine why there was talk about averaging down and whether stops should even be used. Trading the spread is still trading, the rules still apply. It's a losing game, if the position you are in is incorrect, get out, dont hope! I believe Neutral was trading with stops from almost the beginning and was successful for over a year (I don't know whether he is still successful, lets hope so) while others were struggling and complaining about lack of volatility. I also don't understand why the reluctance to trade trends, if a spread seems to be fluctuating around a mean, then look to catch a move towards the mean, if a spread is trending, trade with the trend. Another thing that I wish to have some discussion on is using options. Both on using options instead of buying/shorting underlying in position trades on pairs and maybe even trading spreads between options for different strike/months/underlying? The idea just came to me while reading the thread and was wondering if any of those more experienced with options or spread trading could tell me if there was any use to these strategies.
First off, I can't imagine why there was talk about averaging down and whether stops should even be used. Trading the spread is still trading, the rules still apply. It's a losing game, if the position you are in is incorrect, get out, dont hope! I believe Neutral was trading with stops from almost the beginning and was successful for over a year (I don't know whether he is still successful, lets hope so) while others were struggling and complaining about lack of volatility. I also don't understand why the reluctance to trade trends, if a spread seems to be fluctuating around a mean, then look to catch a move towards the mean, if a spread is trending, trade with the trend. Another thing that I wish to have some discussion on is using options. Both on using options instead of buying/shorting underlying in position trades on pairs and maybe even trading spreads between options for different strike/months/underlying? The idea just came to me while reading the thread and was wondering if any of those more experienced with options or spread trading could tell me if there was any use to these strategies.
Pairs trading is dead...Just look at spread charts. There is no mean reversion, they start moving in one direction and continue to do so day after day after day. This makes it nearly impossible to trade pairs and make great money. I think automation and low volatility have taken much of the edge out of trading pairs.
The good news, if you are flexible and change your strategies to adapt to current market conditions you can make great money. I am making great money by taking advantage of the lower volatility and taking position trades, either long or short.
Mike
The good news, if you are flexible and change your strategies to adapt to current market conditions you can make great money. I am making great money by taking advantage of the lower volatility and taking position trades, either long or short.
Mike
Let me see if I can give some clarification to the words of the imortal mschey: pairtrading as we knew it is dead.
People are having a hard time trading pairs intraday with much success. Whether it is trading off Bollinger Bands, average daily ranges, or pair support resistance numbers, few strategies seem to be providing a big enough edge to overcome commissions on their own.
By changing strategies to use compounding probabilities, and be very patient with capital allocation, we are finding continued success in the pair field. I have been very successful trading pairs in this new manor, and I have been successful in mentoring others to trade pairs in this fashion as well.
Cheers,
djclif
People are having a hard time trading pairs intraday with much success. Whether it is trading off Bollinger Bands, average daily ranges, or pair support resistance numbers, few strategies seem to be providing a big enough edge to overcome commissions on their own.
By changing strategies to use compounding probabilities, and be very patient with capital allocation, we are finding continued success in the pair field. I have been very successful trading pairs in this new manor, and I have been successful in mentoring others to trade pairs in this fashion as well.
Cheers,
djclif