TheBramble
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This is a longish post so please bear with me - or just move onto the next new post!
In the last 5 days when I've been unable to trade, check the t2w forums or participate in the PalTalk sessions, I've been pondering the above issues and playing with spreadsheets - and I'm totally confused.
It all centres on Pair Trading and calculating weighting of the two shares and risk and money management.
I've seen many references (especially from Grey1) regarding getting the ratio of the position sizes correct for pair trading.
Now, I assumed that meant buying fewer of the more expensive share and more of the cheaper share.
But then I got to thinking, in a 'normal' directional trade, I calculate my position size on my max capital-per-trade factor (1% of total trading capital) and the stop loss.
So, if I have a stop-loss of say 15c and a total trade capital of say $50,000, then I would buy/sell shares for a position size that would expose me to a maximum of $500 (and therefore at 15c per share risk) 3300 shares (3300X15c = $500 approx).
However, if I take a pair trade, what should I be using for the weighting or ratio?
Well, surely, it's the stop-losses of the two shares. If one is 20c and the other is 10c, then presumably I'd buy twice as many shares in the stock with a 10c stop-loss as in the one with a 20c stop-loss to a maximum cumulative risk of $500.
Please stay with me, I really need clarity on this issue if you could help me out...
But then I got to thinking, maybe the relative share-price has a bearing...
...and what about relative risk:reward?
For instance, if I have a pair with equal stop-loss exposure, but one has 10 times as much reward potential, wouldn't I buy 10 times as many shares in that stock?
I ended up with a spread-sheet (attached) which mirrors my confusion.
What (or which ) factors should I be using to determine the relative ratio of shares per pair trade - stop-loss, share price or potential profit?
In the last 5 days when I've been unable to trade, check the t2w forums or participate in the PalTalk sessions, I've been pondering the above issues and playing with spreadsheets - and I'm totally confused.
It all centres on Pair Trading and calculating weighting of the two shares and risk and money management.
I've seen many references (especially from Grey1) regarding getting the ratio of the position sizes correct for pair trading.
Now, I assumed that meant buying fewer of the more expensive share and more of the cheaper share.
But then I got to thinking, in a 'normal' directional trade, I calculate my position size on my max capital-per-trade factor (1% of total trading capital) and the stop loss.
So, if I have a stop-loss of say 15c and a total trade capital of say $50,000, then I would buy/sell shares for a position size that would expose me to a maximum of $500 (and therefore at 15c per share risk) 3300 shares (3300X15c = $500 approx).
However, if I take a pair trade, what should I be using for the weighting or ratio?
Well, surely, it's the stop-losses of the two shares. If one is 20c and the other is 10c, then presumably I'd buy twice as many shares in the stock with a 10c stop-loss as in the one with a 20c stop-loss to a maximum cumulative risk of $500.
Please stay with me, I really need clarity on this issue if you could help me out...
But then I got to thinking, maybe the relative share-price has a bearing...
...and what about relative risk:reward?
For instance, if I have a pair with equal stop-loss exposure, but one has 10 times as much reward potential, wouldn't I buy 10 times as many shares in that stock?
I ended up with a spread-sheet (attached) which mirrors my confusion.
What (or which ) factors should I be using to determine the relative ratio of shares per pair trade - stop-loss, share price or potential profit?
