Pairs trading ratio question

[MrMiyagi]

Maybe I'm thinking about this too much , and have got completely confused.. but say I want to buy Barclays @98, and sell HSBC @535, how do I work out how much of each I need to buy?

Given the current price I would have thought roughly 5 BARC to 1 HSBC, should it matter that three months ago that ratio was more like 2 to 1?

Also, when pairs trading, how does one account for volatility in deciding on the ratio? I know it probably doesn't matter much for intra-sector trades like the example above where volatilities are roughly similar, but what about inter-sector trades with two very different volatilities? Do you skew the ratio, and if so, what calculations did you use?

Any help would be much appreciated

 

[Rhody Trader]

If you're just looking for straight out relative performance, then you want equal value amounts on each side of the trade. That would mean roughly a 5.5:1 ratio of Barclays to HSBC.

 

[MrMiyagi]

cheers Rhody, thats what I thought.. any opinions on stuff like volatility weighting etc? does it even matter? its probably something large concerns have to think about...

 

[fibonelli]

The only reason for amending the ratio is where there is a structural reason for one instrument exhibiting lower volatility. Otherwise, you must ensure a fully balanced position at inception.

A classic example is a spread between a 2 yr government bond and a 10 yr gb.

If we assume an identical rise or fall in the bond yield to maturity across the yield curve, the longer dated bond will always move far more than the short dated one in percentage terms.

For example, the Eurex futures exchange amend the ratio to 3:1 if you're doing a Schatz/Bund spread. This is in order to reduce the directional bias (hence risk) of this type of ratio spread.

Finally, I don't believe Barclays/HSBC is an appropriate pair trade in the current market conditions.

 

[MrMiyagi]

The only reason for amending the ratio is where there is a structural reason for one instrument exhibiting lower volatility. Otherwise, you must ensure a fully balanced position at inception.

A classic example is a spread between a 2 yr government bond and a 10 yr gb.

If we assume an identical rise or fall in the bond yield to maturity across the yield curve, the longer dated bond will always move far more than the short dated one in percentage terms.

For example, the Eurex futures exchange amend the ratio to 3:1 if you're doing a Schatz/Bund spread. This is in order to reduce the directional bias (hence risk) of this type of ratio spread.

Finally, I don't believe Barclays/HSBC is an appropriate pair trade in the current market conditions.

cheers fibonelli, that makes sense to me...

Is it the high volatility, risk of one or both concerns going bust, or something else that would put you off this trade?

thanks

 

[fibonelli]

cheers fibonelli, that makes sense to me...

Is it the high volatility, risk of one or both concerns going bust, or something else that would put you off this trade?

thanks

High volatility;
Volatility mismatch;
Although they are both banks, there are important differences. I'll let you work that one out!