Pairs selection and Beta coefficient

[leonarda]

Hi,
I am new to trading (8 months) and still learning fast. I am looking at building a Stock Pairs Trading strategy using my own custom software. One of the issues I can't find much of an answer for in the forums is Pairs selection and Beta analysis. Say take for example at the moment BTEM.L and TEM.L are well correlated and nearly 2 stddev from their mean, shown good mean revertion in the past, but their Betas are:
BTEM.L 0.90
TEM.L 1.58
That means if BTEM.L moves 1% with the Index then TEM.L will move 1.75%, obviously not market neutral. So a simple fix to that would be to Position size accordingly to make it neutral. Is that a correct/good thing to do?, or is there a limit to the difference in Betas that would deem a good pair? I can see over the very short term 1-3 days it's probably Ok, but say the trade lasts 7 days or so and volitility goes back and forth could such a difference in Betas start to become non-market neutral? say the market trends in one direction over that 7 days...

Thanks

 

[-oo0(GoldTrader)]

Beta trading

Aloha Leonardo,
I am not sure that anybody understands your question.

Pair’s selection and Beta analysis.

One of the advantages that we have trading seasonal spreads, is that we can use past reoccurring forces to help us choosing spreads. We know from when the harvest is when to expect a bottom. This influences grains, and the animals that feed off of the grain.

If BTEM.L moves 1% with the Index then TEM.L will move 1.75%

If there was some reason why this happened it seems like when you are bullish the index you would short the index and go long the 1.75 security, trying to make 75% of the move. Everything would depend on your trading the index. When you trade the index outright you would be after 100%.

Position size accordingly to make it neutral.

Position sizing is to determine what your objectives are, and then to determine how much to risk, to achieve those objectives.

Is that a correct/good thing to do?

Depends on your objectives.

say the market trends in one direction over that 7 days...

Well with Seasonals it can trend in one direction for months. What are you asking?
[FONT=&quot]Maybe if you tried your theories on something with a defined seasonal trend, you can get a handle on potential gains?[/FONT]

 

[Martinghoul]

Isn't this all sorta covered by the basics of CAPM?

As I mentioned in your other thread, I'd personally use the ratios that are idiosyncratic to the pair (however you define those, be it simple regression or something more sophisticated). Then you can hedge the beta of your resulting portfolio to make it mkt-neutral.