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Please read the disclaimer. The author is not providing professional investing advice. Alas like many of my so-called brilliant flashes of insight, a little googling revealed that not only had others come up with it decades earlier, but their techniques were more elegant and robust than my first stab. Now anyone familiar with the basic workings of the stock market knows that you can make money in either an up or down market, by using both long and short positions.
But the catch is, you have to know which way the market is heading in order to know which to use. Easier said that done, even for the pros. But with pairs trading, you are performing trades that are theoretically, at least market neutral. As long as the pair ratio reverts to the mean, you make money — regardless of whether you re-arrive at the mean by the short decreasing in price, the long increasing in price, or both. Now I could code up a script to perform correlations between the historical price movements of hundreds of stocks in order to find those that move together, but I have a simpler idea.
To me at least, they are roughly equivalent businesses, and which one I go to depends solely on which one is closer when I need something. They definitely do seem to move together. And I could compute a correlation on the price movements to confirm what I see visually. But perhaps a more important question is not is the relationship between LOW and HD highly correlated, but rather is it mean-reverting.
Because my making a profit depends upon this. So, we appear to know the habits and patterns of this animal. Time to set a trap and lie in wait…. But this creature is dangerous and could eat us alive, so we have to be careful.
We see that in the pair ratio often makes excursions 1 or 2 standard deviations above or below the mean. We could spring the trap then but we might end up making lots of trades for tiny profits, and the commissions could eat us alive too.
Examining the figure above, we do see one time when the ratio appeared to go almost 3 standard deviations from the mean. Therefore that will be our criteria for And a little over a month later, on August 16, , the ratio reverted to the mean so we exited both positions.
So our long LOW position was a Therefore our equal dollar positions averaged out to a 6. And indeed it shortly does. On September 24, the ratio has now gone 3 standard deviations above the mean. So this time we end up doing the reverse as the previous time. And a little less than 2 months later, the ratio has once again reverted to the mean. And this is the last time we get to pounce in And further, we were only committed to a pair trade about 3 months of the whole year.
While we were waiting we could have kept our money in a low-volatility bond index fund e. And should your mean and standard deviations be based on last year or multiple years? A fixed start and stop date or a moving average? Should you jump in at 2, 2. Hey nice blog… I am planning to do a dissertation on pairs trading….
Could you suggest an aspect of pairs trading on which i could do my dissertation…. I think your best bet is probably to check out the following book from one of your countrymen, I believe for a particular aspect that grabs you. Best of luck on your dissertation. Hey thanks a ton, Ive ordered for the same book and also another one from whistler.
Will start as soon as i get them. Also ill try and post you about my progress if its k with you. This is good stuff. Can I ask what resource you use to create your charts. I seem to have gone as far as I can go with Excell, unless there is a way to add the lines noting the standard deviations on the slide with the prices ratios.
I use Matlab for my own analysis. Otherwise you might want to investigate using Excel or OpenOffice Calc. How are you arriving at this figure? And how do you calculate the equivalent dollar values for the pairs.
You could use the ratio on the day that you enter the trade — but this ratio obviously changes as the trade goes on. Thanks for writing Chris. Actually when I went through the math I realized that what I thought was a simple ROR computation is maybe not so simple. The position returns are:. Hi Lumi, I dont have much knowledge about pair trading and statistical arbitrage,but i would love to know about it. Currently i am working as a research associate for equity class.
Manish — see my October 12, comment above for a link to a book in Amazon that is popular re: Not wanting to spam you but this might be helpful for anyone who has really struggled to find affordable retail software that truly does the job of testing and assessing the tradeability of cointegrated pairs.
My partner and I used to model our cointegration pair trades in excel but hit limits. So we decided to build a more flexible and faster tool for release in Q4 this year and will be commercialising it. Obviously we are bullish about the product. But anyone joining the beta starting next month on the current schedule will be able to judge how comprehensive it is for themselves.
Then just multiply by 2 and 3 for the other two numbers. The basic idea behind pairs trading is this: Find a pair of stocks or ETFs whose prices tend to move together. If the price movements are indeed highly correlated, then on most days the price per share of Stock A divided by the price per share of Stock B should come out to be about the same number, within a small range.
If you do, enter a pairs trade. This will involve simultaneously shorting one of the stocks while taking a long position in the other.
At some time in the future when the price ratio hopefully reverts to the mean, exit the pair trade, wire that almost riskless profit to your checking account, and take your wife out to a nice dinner. Time to set a trap and lie in wait… But this creature is dangerous and could eat us alive, so we have to be careful. So we take a This averages to a 9. Backtest to derive your own optimized parameters and have fun.
Hey, Nice blog and article you got here. Hi Srinivas, Thanks for the comments. Also ill try and post you about my progress if its k with you Thanks. Great article but I have a query regarding the dates used for calculating the mean. If a strategy such as this is used when should the mean and std devs be recalculated?
Hi Jadish, I use Matlab for my own analysis. Any info you can provide would be useful! The position returns are: Outputs statistical and fundamental analysis. Details are at arb-maker. Pairs Trading — Level 0 understanding Alphaspotting.
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