Equity Spread Trading Hedge Ratios

Discussion in 'Trading' started by FastandFurious, Aug 10, 2009.

  1. When trading spreads such as MRK vs. PFE whose closing price is 30.10 and 15.96 respectively, do you do 1:2 to balance out the dollar amount?
  2. Volatility weighted would be a more accurate representation. Although, you don't want to deviate (no pun intended) too far from dollar-weighted.
  3. Arnie


    You may also want to weight the long side a little heavier in the current environment.
  4. I can see where volatility be a good play here. I can take the historical volatility of both and do a ratio.

    However, if I just want to be dollar weighted and trade the volatility, it would be 1 MRK to 2 PFE no? On other spreads such as XOM-CVX, there is no doubling...why?
  5. This spread will cost you about $4600 per 100 shares at 1:1 ratio. If you initiated the trade at Friday's open you'd be up $160 or about 3.5% in two days. Not bad.
  6. sjfan


    Volatility weighting implicitly assumes a correlation of 100%. Do so at your own risk.

  7. right, but my question is, do most people trade it 1:2 or 1:1? What are the benefits of each
  8. sjfan


    Both are guess works; It's impossible for one to always work better than the other. It all depends on the correlation between the pair.

  9. Actually, trading dollar-weighted would be an assumption of 100% correlation, whereas volatility-weighted would be an adjustment to compensate for the lack of correlation.
  10. sjfan


    Not True. For two stocks A and B

    Hedging Ratio = Beta(A,B) = Cov(A,B)/Var(B)

    Correlation = Cov(A,B)/Std(A)Std(B)

    If Correlation = 1, then

    Cov(A,B) = Std(A)Std(B)

    Then, substitute this back into the hedging ratio calculation, you get

    Beta(A,B) = Std(A)Std(B)/Var(B) = Std(A)/Std(B) Since Var(B) = Std(B)*Std(B).

    So, under 100% correlation, the correlate hedging ratio is the volatility ratio.

    The correct hedging ratio for 0% correction... is 0! If the pair isn't correlated, it's not a pair trade.

    #10     Aug 10, 2009