Pair Trading

[Sharky]

Hi all,

Does anyone have much experience with pair trading - that is to say, trading the realtionships between pairs of stocks (one that you go long on, the other you go short) enabling you to put on limited-risk traders without having to worry about overall market direction. I'd be interested to know if anyone has used this approach before, and with how much success.

Many thanks,
Sharky.

 

[options]

Yes, but not with shares. It is simply a form of hedging. And yes, it can be successful.

Options.

 

[options]

I thought you were coming up with a new type of competition then Sharky. Pairs trading, mmm I'll partner with Naz then.

Options.

 

[Naz]

Yes Sharky i do it sometimes on the Nasdaq.
I do my research and find two stocks in the same sector one that is weak and one that is strong.Sometimes the semis are good for this.I check out the news on both stocks to get a feel for any reasons for this.I look at both of their performance against the sector as a whole and the tier one general.

Then i stalk them with a level 2 screen.I get to know who the real players are moving the stock.Then at an oppertune time,i hit each on a pullback.Long on one short on the other.Setting a reasonable stop incase i have to re enter.

This type of trade is one that can be held for a lot longer than a daytrade.But during the day i keep looking at the p&l and its this that shows how things are progressing.Many times one will streak ahead of the other in profits so its at this point that i close the weakest (profit wise) and manage the strongest as a normal trade.

Where it realy pays is when they both continue their trends and both show very good gains.The great thing is you dont care to much about overall market direction.Its good fun and because Nasdaq stocks are so volatile at times a great market in which to try it on.

 

[Sharky]

Thanks Naz for the feedback, it would certainly appear to be a strategy worth pursuing.

Options, hehe... I'll leave the real pair trading to Pat and Shane.

Sharky.

 

[Riz]

Yes Sharky, its a good and less stressful trading technique... main issues here, they need to be in the same sector, volatile and liquid enough and you need to do your homework on them as to which been weak/strong, no use in doing it on 2 equally weak or strong ones lol it's best setting a target for the one expected to move more, though L2 helps in establishing entry/exit levels (which is the case on all sorts of trading) you dont neccessarily need it here, while doingyour homework you might as well check closest sup/res levels to establish entries...

Riz

 

[Harrytrader]

If you are interested there is an excel sheet for pair trading
http://www.quotecat.com/ticker_screenXL.htm

 

[TraderPattern]

Another form of pairs trading, that many professionals such as myself and Naz use, relies on the differential between cash price and futures price. When the differential breaches normal bounds, opposing positions can be opened in the futures and the cash (e.g. short the futures, buy the cash), and the positions can be closed at the zero line. The net effect is that you have locked in the arbitrage differential resulting from the futures deviating from their fair value.

The below image displays yesterday afternoon's differential between the S&P futures contract value and the underlying cash value, for the purposes of exemplifying the above discussion. A premium or discount of +/- 0.6 seemed a reasonable trade opportunity, which could be closed out at the zero line. We are relying on the fact that the futures premium or discount is a mean-reverting process, since the existence of any premium or discount will be arbitraged away by people like me.

Note that this technique does not use Level 2, since I am trading a relationship between futures and cash.

But I will always use Level 2 when trading stocks. Pairs trading is something I do when I am bored and can't find stock opportunities. It is NOT my bread and butter, since my Level 2 trading is so much more profitable.

 

[Harrytrader]

Do you know this site ?

http://www.patterntrading.com/fairvalue.htm

Another form of pairs trading, that many professionals such as myself and Naz use, relies on the differential between cash price and futures price. When the differential breaches normal bounds, opposing positions can be opened in the futures and the cash (e.g. short the futures, buy the cash), and the positions can be closed at the zero line. The net effect is that you have locked in the arbitrage differential resulting from the futures deviating from their fair value.

The below image displays yesterday afternoon's differential between the S&P futures contract value and the underlying cash value, for the purposes of exemplifying the above discussion. A premium or discount of +/- 0.6 seemed a reasonable trade opportunity, which could be closed out at the zero line. We are relying on the fact that the futures premium or discount is a mean-reverting process, since the existence of any premium or discount will be arbitraged away by people like me.

Note that this technique does not use Level 2, since I am trading a relationship between futures and cash.

But I will always use Level 2 when trading stocks. Pairs trading is something I do when I am bored and can't find stock opportunities. It is NOT my bread and butter, since my Level 2 trading is so much more profitable.

 

[TraderPattern]

Do you know this site ?

http://www.patterntrading.com/fairvalue.htm

Nope, I don't know it, so I am unable to recommend it.

 

[BeM]

This is just hedging. I don't know a lot but I suppose the market is full of hedgers, daytraders, investors, traders and so on. So the only way to profit most is to choose the right entry and exit method that others don't usually spot, otherwise discounting the spread and the commission the chance of making profit is little

 

[TraderPattern]

This is just hedging. I don't know a lot but I suppose the market is full of hedgers, daytraders, investors, traders and so on. So the only way to profit most is to choose the right entry and exit method that others don't usually spot, otherwise discounting the spread and the commission the chance of making profit is little

If you are referring to my post, I am afraid to say that you are simply wrong. Hedging is about offsetting risk. What I presented is about scalping the premium or discount between the futures and the underlying cash. What I refer to is locking in valuation differentials by taking opposite positions on the futures & the cash, when the premium or discount is significantly away from zero. This is a well known arbitrage technique and is used by investment bank proprietary trading desks.

With regards to your point on commissions offsetting the profits, well that all depends on your transaction size, doesn't it?

Now look at the chart; you will see around 8 opportunities to execute my strategy in the last two hours of yesterday's session.

If I decide to open my trading room to the public one afternoon, you can come and see me execute this strategy live. Although it doesn't make me as much money as my Level 2 trading, this strategy is still viable.

 

[BeM]

TraderPattern,
I read what you wrote but unfortunately I am not educated enough yet, I simply didn't understand it I wrote my post simply as a general idea.

 

[BeM]

Mmmm but if I think abit more I start to understand that you are talking about the diffeence between the real S&P 500 and the ES for example. I have no idea!