Quote from Traden4Alpha:
This is a real challenge. On the one hand you want the short basket to be similar enough to remove market/industry risk factors. On the other hand, the short basket must be dissimilar enough that it doesn't have the same trading set-ups as the long-basket. If the hedge is too similar it moves in exactly the opposite direction as the trade and deftly removes all the profit.
This is a bit easier, assuming the trading setups aren't dependent on profiting from currency fluctuations.
This first one is not a challenge at all.
He's an example (of something I don't have time to trade):
There are 60-70 REITS that trade on the NYSE.
After appplying ** sophisticated quantitative analysis **...
One would always be long 20 REITS and short 20 REITS.
And trade in and out ** extremely actively ** to take advantage of spread and pricing reversions to mean.
Such a portfolio would be HIGHLY market neutral...
And highly profitable... but ONLY in the hands of an experienced, professional quant...
With highly customized, proprietary software.
It would take several years of experience to learn to avoid the pitfalls indigenous to REITS...
And 6 figures to devlop the trading systems over time.
In such hands...
(Do not try this at home)...
The portfolio described above would generate a Sharp Ratio > 3.0
And have maximum drawdowns in the 5-10% range.
There are countless such universes with a full spectrum of risk profiles.
I'm sure the Brights are doing a lot of this sort of thing.
The second part is actually the harder part.
When you hedge against anything external or dissimilar...
You are, by definition, making a ** directional bet **...
In return for, hopefully, lower long term portfolio volatility.
