#### LevII

##### Established member
579 16
TheBramble,

Another way of looking at pairs is to go long the stock which is strong relative to the market and short the weak one.

The idea is that if the market moves up the strong stock will continue to outperform while the weak one will remain so and underperform.

LII

#### TheBramble

##### Legendary member
8,394 1,170

[...]I traded a few pairs over 2-20 days based on a daily/weekly total of best bid/best ask sizes for the top 40 Nasdaq 100 shares.

Can you explain exactly how that worked? I understand the top 40 (by market value I assume), but I don't understand what you mean by "daily/weekly total of best bid/ask". How did you pick pairs based on that data and was it daily or weekly?

If I had based the sizing on each side on the 10 day ATR of each stock, then results were (theoretically) improved dramatically.

Position size in pairs aims to have the same value on each side (e.g. 100 X \$50 stock and 75 X \$67). How would you have applied the 10 ATR to this standard' pair sizing algorithm?

#### TheBramble

##### Legendary member
8,394 1,170
LevII said:
TheBramble,

Another way of looking at pairs is to go long the stock which is strong relative to the market and short the weak one.

The idea is that if the market moves up the strong stock will continue to outperform while the weak one will remain so and underperform.

LII

That's an interesting point too LevII.

It would be an interesting exercise to do a correlation of the two approaches.

My own gut feeling is that there's less 'to go for' in the same direction if there's already been a sustained trend in that direction. Could be wrong though. (Frequently am!).

#### rog1111

##### Established member
673 10
Re: Re: Re: Market Neutral Trading

The Bramble

To clarify, I used 2 approaches. Daily totals were used as a basis for the shorter term positions (2 - 5 days) and weekly totals were used independently for longer trades holding for up to 20 days.

The totals themselves were collected via an Excel VBA routine written specifically for the purpose, which would run all day during market hours. At the top of the bid and ask the prices/sizes would constantly change. For all Nasdaq 40 stocks (in order of Index weighting), the sizes were summed continuously on both sides, with a couple of conditions, eventually arriving at a ratio of all bids:all asks. From memory I can tell you that the ratios usually varied from approx 0.5 to 2 - the higher the ratio the higher the relative (temporary) strength of the stock. So the 2 extreme stocks out of the 40 were chosen as candidates for short/long. I could have done this for all 100 stocks, but PC resources were under pressure with all the live Excel links.

I realise that equal dollar amounts on each side are commonly used. However, the 10 day ATR approach could be used as follows. First calculate the 10 day ATR of both stocks, as a % of their last closing price. Suppose the Long stock was SBUX with an 10dATR of 2%, and the Short stock was MSFT with a 10dATR of 1%. Regardless of the \$ price of each, I would want to be holding twice as many dollars worth of MSFT in this case, in order to attempt to balance out my risk eg Short 400 [email protected] = \$10,000, Long 200 SBUX @25 = \$5000

Suppose then on the next day, both stocks went up by a price movement equiv. to their 10dATRs, the position would have been :
MSFT -1% x 10,000 = -\$100
SBUX +2% x 5,000 = +100
total = \$0

If I had gone \$ neutral with \$7500 on each side, and the same pricre movement occurred, we now have :
MSFT - 1% x 7,500 = -\$75
SBUX +2 % x \$7,500 = +\$150
total = \$75

OK the latter model gives a better PL in this case, but the point is that I am trying to balance things more effectively and reduce the effect of the more volatile stock on the overall position. If the above moves had been the other way round then the second model would have been more negative than the first. If you just go \$ neutral without considering price volatility (ATR), then one stock may be way more volatile, and will dominate the whole position almost as though you were just trading the one side.

I hope this makes sense and that I have got my figures correct - it's getting late & my brain is tired !

rog1111

TheBramble said:

Position size in pairs aims to have the same value on each side (e.g. 100 X \$50 stock and 75 X \$67). How would you have applied the 10 ATR to this standard' pair sizing algorithm?

579 16

#### TheBramble

##### Legendary member
8,394 1,170
Rog1111 - thanks for your reply. I'll print and read it offline where I can give it the attention it deserves. Looks interesting.

LevII - I only pair trade a trendless market. Maybe that's the key point as the two approaches are diametrically opposed (just as is an oscillating market is to a trending one!).

#### RogerM

##### Established member
752 6
rog1111 - I'm a little confused as to why you'd want to pair trade MSFT/SBUX. My understanding of a market neutral pair is that you choose 2 stocks from the same sector so that the same news/geopolitical events affect both stocks in a similar way. e.g. 2 retailers or 2 financial. By picking two stocks in different groups or sectors you could be doubly wrong, with the short stock rising and the long stock falling, although I suspect that youd still be adequately hedged the next time someone flys a plane into a building.

As a first step, I'm going to look at correlated stocks within the same sector using "match-maker" within AIQ to find stocks with a high degree of correlation over 12 months, and then look at the ones with greatest and least RS to the sector. This should be a simple approach that should be relatively easy to back-test as well, which is a bonus.

An alternative approach is the sector rotation approach mentioned by TheBramble ( and hopefully this is what he means) where you look for strong and weak sectors, and then short the weak stock in the weakening sector, and go long the stronger stock in a strengthening sector, BUT ensuring a high degree of correlation if possible. My initial thoughts are that you should be looking at sector charts first, and looking for buy/sell signals in the sector charts before looking for pairs within the sectors.

Thanks again for bringing this up Niall - opens up a new field to explore.

Moderator
8,655 981
Position size is also an important factor to consider when pair trading. For example a \$20 stock is not likely to have the same ATR as a \$60 stock. I would consider trading by the ratio of one to the other so that you improve your chances of a truly market neutral strategy.

Paul

#### rog1111

##### Established member
673 10
Hi Paul

This is about position sizing really. I don't think that the stock's price is necessarily indicative of it's likely ATR when the ATR is expressed as a % of the price eg \$20 stock might have an ATR of \$1 = 5%, 60\$ stock has an ATR of \$6 (that would be nice) = 10%. Which is the more volatile ? In this case, from a position sizing point of view, the \$60 stock is twice as volatile. Personally, based on previous observations, if I was trading one against the other I wouldn't want to use a \$ ratio of 3:1 based on price, rather 2:1 based on volatility. But others may be happier going with 3:1 - just my opinion

rog1111

Position size is also an important factor to consider when pair trading. For example a \$20 stock is not likely to have the same ATR as a \$60 stock. I would consider trading by the ratio of one to the other so that you improve your chances of a truly market neutral strategy.

Paul

#### rog1111

##### Established member
673 10
Roger

Granted, what I described is this example does not involve stocks in the same sector, rather just another Long-Short method based on :
a) the selection procedure that I outlined in an earlier post
b) volatility sizing
c) the idea that most Nasdaq 100 stocks will behave in a somewhat similar fashion in times of crisis (or elation)

Yes, I could be doubly wrong, maybe on more occasions than with same sector stocks, maybe not. The success of this approach simply relies on the effectiveness of the excel collection method at identifying a strong stock and a weak stock, based on total bid/ask sizes, and good position sizing based on volatility (ATR). Just a different approach.

rog1111

RogerM said:
rog1111 - I'm a little confused as to why you'd want to pair trade MSFT/SBUX. My understanding of a market neutral pair is that you choose 2 stocks from the same sector so that the same news/geopolitical events affect both stocks in a similar way. e.g. 2 retailers or 2 financial. By picking two stocks in different groups or sectors you could be doubly wrong, with the short stock rising and the long stock falling, although I suspect that youd still be adequately hedged the next time someone flys a plane into a building.

As a first step, I'm going to look at correlated stocks within the same sector using "match-maker" within AIQ to find stocks with a high degree of correlation over 12 months, and then look at the ones with greatest and least RS to the sector. This should be a simple approach that should be relatively easy to back-test as well, which is a bonus.

An alternative approach is the sector rotation approach mentioned by TheBramble ( and hopefully this is what he means) where you look for strong and weak sectors, and then short the weak stock in the weakening sector, and go long the stronger stock in a strengthening sector, BUT ensuring a high degree of correlation if possible. My initial thoughts are that you should be looking at sector charts first, and looking for buy/sell signals in the sector charts before looking for pairs within the sectors.

Thanks again for bringing this up Niall - opens up a new field to explore.

#### RogerM

##### Established member
752 6
Yes, I could be doubly wrong, maybe on more occasions than with same sector stocks, maybe not.

And of course you could be doubly wrong if you just go long 2 separate stocks. At least with this method, even with pairs from different sectors you are protected to a degree from the worst excesses of major geopolitical risk which would take all stocks down with it, regardless of sector. It's just a case of how "market neutral" you want to be I guess.

#### Niall

##### Junior member
28 1
Its good to read of the various approaches to this strategy, its definitely clear that there are numerous ways to tackle it and great to hear peoples thoughts on the topic..

I may have said this earlier, but anyway, one thing I have noticed is that as my confidence and success in my own particular genre of market neutral trading has grown.. so has the work that I put it to it.. which is right and proper really.. read so often of the daytrader mentality of being able to roll out of bed in the morning (the usa types anyway!) stumble across to the monitors... trade the first hour ("its where I make all my profits, whats the point of trading at any other time?") make a quick few grand.. and then topple back into the pit until time to go to the beach... haha

Ah well.. I was never quite like that.. way too old.. but it did seem at first as if money could be made without too much effort.. sure learned that was not the case.. at least for me.. altho I accept that there are little genies out there who can do it as natural as boil an egg.. but I do not care if I never hear another bouncy exhuberant word from that sort.. please!

For me the work is welcome.. makes me feel as if I deserve any gains I make.. and I think trading is best suited to a compulsive type of personality too.. which I guess is me.. I seem to spend a huge amount of my time thinking or talking about trading.. I am fortunate in that my wife shares the obsession and so our leisure time often involves plotting and planning and discussing.. never really get tired of that side of it... we might take the dog for a walk along the shore... and in between throwing sticks for him.. and admiring the sound of the waves breaking on the rocks and the view across galway bay to the mountains of connemara.. we will be chatting about the latest pair performance.. or better still.. which bit of the cote d'azur we will move to when we finally get this working right.. nuts right? lol

#### TheBramble

##### Legendary member
8,394 1,170
RogerM said:
An alternative approach is the sector rotation approach mentioned by TheBramble ( and hopefully this is what he means) where you look for strong and weak sectors, and then short the weak stock in the weakening sector, and go long the stronger stock in a strengthening sector,

Rog, wasn't my post on sector rotation. And my approach to pairs is quite the opposite to the one you state.

I short the strong and go long the weak.

#### rog1111

##### Established member
673 10
I agree. The main point that I had been really trying to get across was that sizing on each side is a critical factor, and for my strategy at least, a volatility neutral long-short approach seems to outperform \$ neutral pairs, historically.

rog1111

RogerM said:

And of course you could be doubly wrong if you just go long 2 separate stocks. At least with this method, even with pairs from different sectors you are protected to a degree from the worst excesses of major geopolitical risk which would take all stocks down with it, regardless of sector. It's just a case of how "market neutral" you want to be I guess.

#### RogerM

##### Established member
752 6
Rog, wasn't my post on sector rotation. And my approach to pairs is quite the opposite to the one you state.

Tony - lol - That's what makes a market!

And in fact we could both be right provided we are using methodologies that work for us. Or of course we could both be wrong.

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