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hedging a...... pairs trade

  1. since so many prop traders trade pairs(in this case a pair in stocks/ETF/Indexes))

    recognizing that a pairs trade is a spread(one position long, one position short)and is already partly hedged, how have some of you been practicing risk management?

    adjust position sizing? use options(assuming one of the stock/ETF/Indexs are Optionable), some other strategy?
     
  2. Tight stops.
     
  3. Just keep the $$s long and short. Now, don't misunderstand what I'm saying here. Many of us tend to keep about 10% long to make up for the normal upward bias of the market. You can adjust this with your own interpretation of near term market correction of course.

    Don
     
  4. Don

    can you clarify? I guessing you mean avoid being strictly dollar neutral and skew one side by a percentage. or do you mean something different?
     
  5. Yeah, pretty much..decide a good ratio enter the trade. I use a 130 to 100 on one of my pairs to start with. I can normally put on a couple of layers, and close them same day or in a day or two max. But sometimes, it just makes sense to adjust the share ration (monthly seasonality, things like that).

    We have hundreds of pairs, with various ration, showing dozens of column of analytics to work with, adjust as needed.

    Keeping it simple, once again, LOL.

    Don
     
  6. gotcha. and is "layer" your term for adding more shares to both sides of the spread....when warranted?
     
  7. In Vegas, it's called martingaling. :)

    Sorry Don, that was a softball.
     
  8. Yep. Trading range from say, $40-$60 for last 6 months. Two stocks, range of differential say $5.00 during that time. When spread goes to $4 you sell a layer, maybe 2 layers...since you don't want to take the first layer off....(sidebar: reason for this is that if this goes against you, you add another layer. But if you 50 cents or whatever, you close out...well, what happens when it goes $3 more in your direction? Right, no profit).

    Then if goes up to near $5 you can sell another layer, have either two or three max (for now), take off on with at least 10% of the 6 months range $.50 for this example. Keep the other one with a "mental" trailing stop or trigger.

    Don
     
  9. All about proper trading size. With limits, Mr. Maverick. As you know, when we do martingaling, its at baccarrat...and don't suggest it, LOL. Stupid table limits....have to recruit family members to increase bet size....

    Don :)
     
  10. Try swing trading them for trend, and quit playing rich / cheap fade-monkey. Works wonders. You might want to hang on to them a bit longer due to the stat arb turbulence.

    I agree about keeping your longs and shorts dollar-equalized. And choose sensible combinations within correlated market sectors and similar market caps if you can. I've also had clients cut back on trading size and position selection during earnings season.

    Love that Bloomberg beta scatter-plot functionality.
     
  11. Bone

    I'm not new to spread trading(did some commodity futures spread trades in 2008-2008) but I am new to stock/ETF/Index spread(pairs) trading. the "homework" I've done shows that even more than doing correlated pairs is to make sure that they are cointegrated. so I'm only trading them if the cointegration is over 90%.

    that and similar to what you mentioned, no pairs trades before any of the company's earnings releases
     
  12. cointegration is like pregnancy. either cointegrated or no. there is no such thing as 90% cointegrated. you either reject or not reject.

    maybe you mean cannot reject at 90% confidence?

    maybe you mean 90% correlated?
     
  13. do not look at dollar spread. it is not beta neutral.

    look at the spread in log prices.
     
  14. NJrookie



    the information sources I've researched are telling me to the contrary. i.e. there are degrees/percentages of cointegration. there are multiple sites(and software available) computing this number(one site is using the Dickey Fuller formula to compute this, for example). and there are other formulas(Pearson)

    if you disagree with this, I guess you can take up with them. yet what I know(for now) is that a highly correlated pair is alright yet being highly cointegrated is better. and that a trader should screen for BOTH

    if you have traded pairs of course, and have been profitable, then feel free to respongd
     
  15. I am pretty sure standard DF test is for confidence, ie you cannot reject at 5% / 10% / 1% confidence interval.

    I have trade pairs for over 3 years and I teach econometrics for living in a univ.

    njrookie
     
  16. You could always make a directional trade with stop to protect your downside

    You can take a big loss on a hedged position all the same .. no easy money

    I would rather take a directional trade & manage the risk . less work to me
     
  17. Cointegration is determined by a 'critical value' (a t-value in the form of a rational number) and an associated confidence level (decimal).

    Dickey Fuller is a test for unit roots. It does not produce output that says this pair is x% cointegrated. Yet a few sites do indeed tout what looks like a p-value and claim it's a % measure of cointegration.

    DF can tell you if the two data series before you might be mean reverting - which may, for example, assist correlation-based pairs trading. But that's different from using cointegration.

    A cointegration test (like Engle-Granger) applies DF (or ADF) to the level prices of a pair, their differences and then - if those two results are satisfactory - to their residuals.

    But it is possible at the end of the process to say 'this pair is more cointegrated than that one' if its t-value is more negative (and the two pairs considered are both at the same confidence level).

    Hope this helps.
     
  18. you are trading. nothing is really cointegrated end of day unless they are same underlying with different leverage built in. forget all the academic cointegration test. it gives you a false sense of security if the test cannot reject cointegration. it is mostly lack of power or lack data in testing.

    if the correlation is too high, there is nothing to trade on. if too low you are cannot achieve hedging. you are managing a risk for short-term trading. the difference is not really meaningful.
     
  19. Suggest you also have a look at RRG on your terminal