spread trading

L

lescor

There is a smattering of info on elite about arbitrage trading, but not much. Maybe we could have a forum for people who are interested in this strategy to discuss their ideas.

I posted a reply to a question in this thread :
http://www.elitetrader.com/vb/showthread.php?s=&threadid=5998&perpage=6&pagenumber=2
(Forums ›› Tools of the Trade ›› Software ›› Pairs/Basket trading software needed!) I don't want the info to get lost in the software forum, so I'm re-posting it here.

I'm doing some pair trading now based on the same article (and Reverre's book). I've built a pretty in depth excel spreadsheet that I feed live data using qlink. It produces charts on 5, 15, 60 minute and daily time frames. I chart the ratio, the dollar spread and the standard deviation of the spread. I also use qcharts to chart the spreads and put bollinger bands on them using a 30 period avg and 2 st dev.

It's working ok so far, but the biggest issues for me are controling the risk and handling spreads that are trending. The numbers that make a trade look attractive are subjective and there is no defined relationship between the stocks like with a merger spread. So you can expect the trades to go against you quite often. Statistically, the further it deviates from the mean, the higher the probability that it will come back. But at what point do you finally bail on a losing trade? You can try to take off all or part of one side to capture part of a move, but then you are making a directional bet on the market, which you don't have to do when you lock in the spread right away and just leave it. You can also only trade one of the stocks, leaning on a bid or offer in the other one. Of course if the trade goes against you and you lock in the spread, you're still in the same position. I've talked to traders that add every 50 cents that the trade goes against them up to three times. But then when it comes to the fourth time, you are down 2 bucks in the trade with 4 times your normal position size.

Would like to hear comments from other pair traders on your exit strategies and risk management rules.

Corey
 
Originally posted by lescor
There is a smattering of info on elite about arbitrage trading, but not much. Maybe we could have a forum for people who are interested in this strategy to discuss their ideas.

I posted a reply to a question in this thread :
http://www.elitetrader.com/vb/showthread.php?s=&threadid=5998&perpage=6&pagenumber=2
(Forums ›› Tools of the Trade ›› Software ›› Pairs/Basket trading software needed!) I don't want the info to get lost in the software forum, so I'm re-posting it here.

I'm doing some pair trading now based on the same article (and Reverre's book). I've built a pretty in depth excel spreadsheet that I feed live data using qlink. It produces charts on 5, 15, 60 minute and daily time frames. I chart the ratio, the dollar spread and the standard deviation of the spread. I also use qcharts to chart the spreads and put bollinger bands on them using a 30 period avg and 2 st dev.

It's working ok so far, but the biggest issues for me are controling the risk and handling spreads that are trending. The numbers that make a trade look attractive are subjective and there is no defined relationship between the stocks like with a merger spread. So you can expect the trades to go against you quite often. Statistically, the further it deviates from the mean, the higher the probability that it will come back. But at what point do you finally bail on a losing trade? You can try to take off all or part of one side to capture part of a move, but then you are making a directional bet on the market, which you don't have to do when you lock in the spread right away and just leave it. You can also only trade one of the stocks, leaning on a bid or offer in the other one. Of course if the trade goes against you and you lock in the spread, you're still in the same position. I've talked to traders that add every 50 cents that the trade goes against them up to three times. But then when it comes to the fourth time, you are down 2 bucks in the trade with 4 times your normal position size.

Would like to hear comments from other pair traders on your exit strategies and risk management rules.

Corey
More...

Corey,

To which Reverre book are you referring?

Thanks!
 
It sound like you are trading spreads on stocks. I trade spreads using options, and the risk is very small.

If anyone else is doing this, let me know and we can compare strategies.

Ron
 
06-05-02 01:58 PM
spread trading
It sound like you are trading spreads on stocks. I trade spreads using options, and the risk is very small.

If anyone else is doing this, let me know and we can compare strategies.

Ron
----------------


Hey Ron, thanks for sharing but just a couple of questions....Given you are using options to capture the spread movement between two stocks, don't you find there is a lot of slippage when trading less than a full delta?

Or are your holding periods sufficiently long to overcome the bid/ask (option) spread problem; or are you trading deep in the money options?

Royce
 
Originally posted by lescor
I've built a pretty in depth excel spreadsheet that I feed live data using qlink. It produces charts on 5, 15, 60 minute and daily time frames. I chart the ratio, the dollar spread and the standard deviation of the spread. I also use qcharts to chart the spreads and put bollinger bands on them using a 30 period avg and 2 st dev.

... but the biggest issues for me are controling the risk and handling spreads that are trending.

Would like to hear comments from other pair traders on your exit strategies and risk management rules.

Corey
More...

Since you've already got the QLink and QCharts setup, why don't you take that synthetic price series that you've created from the spread, export it to ASCII, and test it just like you'd test any other time series in the software of your choice. Try different BB levels and evaluate the Maximum Adverse Excursion. If the software package will let you also consider position sizing, then all the better.

With Win/Loss statistics, Max Draw Down, average losing trade, etc. you'll get a pretty good idea of what your account will look like, as well as figure an Optimal f or some other position sizing method for trading that pair.

Most intraday symbols in QCharts will go back to 4/8/1997, so you'll have plenty of data to work with. You could probably even test this in 65,000 bar blocks right in Excel. Set a flag in one column if the price is outside those bands, evaluate how many points outside it travels each time, and create a distribution of the results. Then you can visually get a feel for how far and how often that trade moves against you.

I'm not advocating that this become the basis for a mechanical pairs trading method, but it will at least help you characterize that pair and size accordingly based on risk, as you've indicated you intend to do.
 
I can tell you are experienced by your question.

You are right, I am buying deep in the money options where time value is close to zero and writing at the money options where time value is at its maximum.

The underlying security is the same on both legs, by the way.

Have you done anything similar to this?
 
Ron,

I have never executed any option trades for spreading purposes only, as you are doing.

In the past I would use options to hedge off the breakup risk of my merger trades. But currently, I am considering the efficacy of using options to capture profits on paired stock trades.

For instance, I just recently covered Short 3*SSCC and long TIN for a good profit. Now, I want to find out what my return would have been if I had instead bought 3 atm puts on SSCC and was long one atm call on TIN.

Royce
 
I have never opened an options spread on two different underlying securities like you're suggesting.
I really don't consider that a spread because the two securities might move in the wrong direction for you so the limited risk that you get with a traditional spread is lost in that case.
Normally one side of a spread protects you if the security moves one way and the other side of the spread protects you if it moves the opposite way. The profit is attained when you capture the spread between the two legs.
In your post, you said you would "buy an at the money put".
I never buy at the money options since they contain the most amount of time decay. Those are the ones you want to write, not buy.
You know where I'm coming from?
 
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