Mean reversion pairs trading, long with short

Discussion in 'Strategy Development' started by markd01, May 30, 2011.

  1. markd01

    markd01

    When you trade mean reversion, would you want to require 1 long position to always go with 1 short position, even if one of the two was not the highest probability signal? I wanted to build market neutral portfolios, but found that in reality I'd enter positions according to market conditions. For example, if your ultimate goal is to have up to 10 positions in a portfolio, 5 long and 5 short, you'd enter long positions as markets are oversold, and then enter short positions as markets are overbought. In a lot of cases, it would mean that half of your portfolio is sitting in cash (which is not such a bad thing, as it lowers risk).
     
  2. Trader13

    Trader13

    Your implementation approach does not align with your objective concepts. If your intent is to maintain a market-neutral portfolio with returns deriving from mean-reversion of the components, then you need to open all your positions at the same time. If you are making judgements about some components being oversold/overbought and just starting by opening those positions, then you are making a directional bet on those stocks, not a mean reversion bet. You would actually have MORE systemic risk in the case where half your portfolio is in cash, because your directional position is not hedged as it would be with a market neutral portfolio where every long has a corresponding short.
     
  3. markd01

    markd01

    Trader13, thank you for your answer. It made me realize that focusing on different risk to reward ratio objectives was more important to me than on just lowering market risk with market-neutral portfolio.