This is a primer for the uninitiated in pair trading / investing. This chart illustrates from yesterday and today a hedged pair's indifference to .... (1) the general market's direction; (2) the pair's own direction and steepness of decline <img src=http://www.elitetrader.com/vb/attachment.php?s=&postid=3817949 >
HOT Short HST Long Closed for a scalping opportunity. PURPOSE FOR LONGER TERM PAIR TRADE IS STILL INTACT. Opportunity to get back into long term pair trade will come soon. Pair Trading is multi-faceted for money making. See chart for one trader's simple rationale for scalping short term quarters on the way to a longer term Dollars pair trade. http://www.elitetrader.com/vb/showthread.php?s=&postid=3819039#post3819039 Although this is just a scalp on the way to a bigger trade of the same pair, it is a valuable example of trading inside of an existing pair trade. Lesson: Scalps can be picking up frequent quarters on the way to the BIG DOLLAR. I'm NOT an avid scalper, but when the opportunity sticks a big thumb in my eye that says it is free money, I will do it. Many pair trades develop a rhythm while waiting for the trade to mature into a nice gain. Sometimes closing out an exiting trade like I did while waiting for the big dollar gain is ok when "early" in the trade. Another plan is to open TWO exact trades: One waiting patiently for the big pair trade to make the big money and the exact second pair opened at the same time to take advantage of scalping and used exclusively for scalping should this pair become a rhythmic oscillating spread. This way, the big money trade is not missed should the second simultaneous trade that scalps turns out to be a premature closing as the spread continues going favorably after the close of the scalp which allows the first of the two simultaneous trades take advantage of the continued favorably developing spread.
RAI Short PM Long A remarkable opportunity ? Charts posted during trading session today. Two charts for review at Charts of Note thread: 18 mos and 5 wks. http://www.elitetrader.com/vb/showthread.php?s=&postid=3831224#post3831224 Only 3 times on a 20 yr chart has PM dipped below RAI, twice were minor compared to today's spread. The third time was during 9-11 attack on the U.S., and the current dip has already progressed half that distance in spread. Not only were two dips minor, but all three were relatively short in duration from 1 to 3 months. Currently this looks like a severely stretched rubber band. And even if it stretches more, the 20 year chart indicates recovery (and gains from this point) within three months. RAI has a smooth channel during those 20 years, while PM with its higher beta swings in and out on PM. This pattern provides a safety net of high probability--chart wise--indicating any very short term, unbooked loss in a newly established position put on now can be recovered in a few months....a few months that the chart shows could be a nice gain. This trade is characterized more as an intermediate term swing trade where longer time in a position is intended to have larger gains than short term trading. That is not to say this swing trade can't make immediate and notable gains.
The following discussion is (1) my answer to koolaid about a question of correlation he had following my series of two charts I posted tradable at Charts of Note. http://www.elitetrader.com/vb/showthread.php?s=&postid=3832744#post3832744 (2) my happy style of pair trading not being obsessed with correlation, but rather my higher priority on co-integration, and my results generally. (1) koolaid.........Look at the LONG TERM (10 year) long track record and then the SHORT TERM (9 months) to see the beautiful correlation. Now on the 9 month chart (not posted) there is sloppiness this spring for a few months and much more of a break down this month of June. It would be interesting to know how that formula weighs real short term (like 1 month) in the over all formula for correlation that Think or Swim uses. The recent break down on that chart could be a big influencer if a 1 month chart is weighted heavily. (2) From my years of trading pairs, I have never searched out correlation numbers. I am purely a picture man. Heck, I never go into a trade looking at fundamentals. I've never needed it nor technical analysis. That makes what I do a pretty easy learning curve to get into it. For tight correlation over any time period look at WRI KIM. Tied at the hip. Very recently it had a (relatively) big divergence (spread) I have never seen before with this pair. It was a bet the farm opportunity. I rarely find those things. DIA and SPY are damn close, but you have to throw a lot of money at that pair as they are priced expensively. I recall Jan 2011 and May 2011 were good times to get in on a SPY DIA divergence, but you needed to be prepared to hold on for 4 to 6 weeks. To make it worth it, you had to throw a LOT of money at it, unless you could figure an options play. Since I am a picture trader, I am more influenced by co-integration. In lieu of strong correlation, all I need to see is frequent convergences and divergences (co-integration) and in a predictable (safe) range. I start from outer space or 20 years to eliminate the obvious candidates. As I zoom in closer then closer, then closer, I observe correlation and cointegration. I am either impressed or not. There is an important manner by which to choose dates for new starting points when shortening the time frame. Beyond that is neither science nor abstract, but rather practical sense conclusions. When you have identified a population of possibilities, you trade the best and put the rest on your watch list with the occasional thowing some out and adding some. I am never at a loss for many possibilities to trade. It is a matter of prioritizing. Money management is important, too, as you have to have enough powder to add to the trade when an additional layer is called for. (This is where the big money gains come from. It is interesting that others would be watching for the trade coming closer to an established stop, while instead I get excited about the prospect of making big money from this higher probability bigger gain situation.) Weeks and weeks of boredom from modest gains yet very HIGH ratio of booked gains compared to total trades opened characterizes my style of pair trading. This weeks of boredom is broken by the orgasmic experience of the big gain, usually from the multi-layers on the trade. It is more probable and frequent to have the very nice gain, instead, that happens more often. My closed, bad experiences can wipe out (equal) 3 to 4 of my ordinary gains, throw in a very nice gain or two, also. The trade off is nice over all nets and even peace of mind, unconcerned about direction of market or even huge spikes up or down in the market; just comes with the territory being hedged. This style of trading is not living on the edge.... only peaking over it occasionally.
APA Short DVN Long These two charts were posted yesterday but the train has not left the station yet. In fact the spread is more favorable to open trade today than yesterday ! Charts are where they always get posted at Charts of Note thread under the TRADING forum. (A five star thread.) http://www.elitetrader.com/vb/showthread.php?s=&postid=3832744#post3832744
APA Short DVN Long Chart 3 Trade closed (1) Terrific scalp opportunity the 2nd day of trade (2) Very nice gain from the opening trade to close in less than a week. http://www.elitetrader.com/vb/showthread.php?s=&postid=3835854#post3835854
RAI Short PM Long Chart 3 Illustration of 3 layers installed, the 3rd one today. http://www.elitetrader.com/vb/showthread.php?s=&postid=3840560#post3840560
At the TRADING forum and its Charts of Note thread where I post my charts, I was asked the following ....... The trading world within the context of the subject of "discipline" has the use of stops. I learned quickly with my my particular, self-made style of of pair trading as it evolved the first year I pair traded that stops were highly self destructive rather than self preserving. The reason that sounds insane to experienced traders is because, I think, the enormity of the trading world and its common theme of protective stops is appropriate wherever you look. However, in my style, rather than pre-determining a stop, instead I use a process of stopping. Anyone uninterested in checking into the simplicity of pair trading, will find the following subject of "stops" tedious, I suppose. But pairs trading my style is fun and steady income with relatively less risk and less need for frequent use of stops. Those courting the notion of pair trading will get constructive insight from my addressing this specific subject of "stops" that will carry over in to an advantage trading pairs my style. I can't help but believe that "trying" will result in either extreme: ho-hum OR passionately willing to pursue it. Results will almost be immediate as my style comes with only a brief learning curve. I also believe there is an enormous population of non-traders that just want to move their portfolio into better returns than 2%, and with just a little effort can apply a degree of my style which is more investor friendly and less trader frenetic than conventional pair trading or any other style of trading I am aware of. Non-sexy investing with steady, respectable investment income without having to predict market direction that only requires a modest degree of being pro-active is how I describe my style. For greater returns, the investor could dial up to more frequent "trading" should the trading bug motivate. My empirical evidence that pre-calculated stops don't work in my style of pairs trading which is swing trading in flavor is suggestive to me that this "hedging" of pairs is some kind of different animal to begin with. My style bakes in safety relative to other trading I know which innately calls for fewer needs of "stops." That is not true from what I know of conventional pairs trading that is more highly oriented to arithmetic and statistical arbitrage along with shorter times in trades and smaller tolerance to unbooked loss in the trade than for my style. Where others would be bailing out, I find that same degree of unbooked loss for me to be the approaching proximity of a threshold of explosive gains being a high probability OR frequently slower, steady, unbooked gains that start at the most recently installed layers and trickle down into earlier installed layers. I learned from my early years of pair trading my style that when I broke from adding layers, I quickly became disappointed. To reinforce my confidence of the trade before I make a decision in a multi-layered posture, I go back to studying what made me begin the trade. I also search for fundamentals of the companies that occurred while I was in the trade that were disfavorable to my position. (At other times I don't use fundamentals.) Generally, disfavorable fundamentals occurring while in the trade either individually or in the aggregate have to be very significant to move my needle toward closing a trade. They have to be impactful enough to compromise the "rubber band stretching" formation of the stock plots so significantly as to make me believe I could be carrying dead money for possibly eternity. Otherwise, I keep the faith in my position knowing from personal experience that a rubber band that snaps back is just as likely as entering a new, promising trade. I am not against taking losses when I deem them to be for my best interest. (1) In multi-layered trades, when justified, I will book gains on the most recent layers while closing out with a loss on the original first layer. But I will be very thoughtful before booking a loss on that original first layer, reviewing again why I got into the trade and the disfavorable fundamentals that occurred while in it. I also am mindful of how the plots behaved as they went against me, returned favorably to me, and the "rhythm" if any of how the position developed a profile for itself formed by the frequency with which there was oscillation moving away from gains and returning to gains. Sometimes this results in a net positive gain, sometimes in a net loss that is small relative to the aggregate loss territory I had found myself in before the plots turned favorable for me. (2) The frequency of booking a loss occurs more often for me with just one layer or soon after installing a 2nd layer that is enjoying a relatively small gain or loss. In this scenario, I am driven to closing out the trade because after re-examination of cause for getting into the trade I determine either by objective analysis or instinct, I could do better and faster somewhere else. So here is an occasion where I am reviewing in depth why I got into the trade in the same manner as described earlier with multi-layered trades. There was something here that didn't suit me as well as when I started the trade. I may have made the decision to close out just before tactfully adding a second layer. Adding a second layer is done (adding more risk) when I have determined, yes, I will be closing out totally, but not before I take advantage of a rhythm the trade has expressed that allows me to be confident that the second layer will enjoy a degree of success. This will mitigate the net loss. I have referred to oscillating rhythms of a pair that move my position toward gain and then to loss and then to repeat again and again. Happily this occurs essentially at the same limits in either direction. In all occasions and with all existing layers simultaneously, one can scalp this rhythm of predictability. It is pleasing that these incremental gains inside the longer trade objective of the pair can mitigate loss incurred from an eventual decision to close out with finality a pair trade. In some small way it can influence stopping all trade in the pair that appears to be too challenged to meet the longer term objective. Reading the above by the unpracticed pair trader is academic but hopefully motivating. Experiencing it is empowering and confidence building. In the final analysis, I don't believe there is any organic advantage I had when I started pair trading that exceeded that possessed by anyone else. My results since beginning to pair trade my style are booked trades with gains easily over 80% of all trades I put on, and I am being conservative. Many losses experienced at specific layers of a pair are not much more than a typical gain at that level on winning pair trades. My more notorious losses number few and each wipe out approximately three times as much gain at those layers experienced from winning pair trades. With the relative ease of hitting singles and doubles while experiencing the occasional triples and home runs all in the context of non-concern of market direction and no need for pre-calculated stops and their frequent frustrations, my style of pair trading tends to maintain stable, mental hygiene while having fun doing it. It lends itself very well to a more investing nature with the appropriate pairs if one is inclined to approach it that way rather than frequent trading. Good trading and prosper !
PM being the Long leg has generally been correlated with market direction, but weak. RAI being the Short leg has been since the trading pair opened on a terror screaming upward. I have added two layers taking advantage of the stretching rubber band, widening spread. A number of days ago I concluded RAI the Short was being over bought running towards earnings report tomorrow. In deed, its sell off these last three days (and now the day before earnings report) has corroborated my conclusion. Profit taking has been in high gear for holders of RAI Longs these last three days, rapidly plunging from its peak. The rubber band was over stretched and has been snapping back. Actually I was expecting this tomorrow with earnings report for RAI even if earnings report is favorable for RAI (but hopefully not too favorable !). My thinking has been for many days that in RAI's overbought condition, meeting earnings expectations or even if slightly better than expected is reported, it will sell off with big profit taking for the Long's and do wonders for having it as a short. Although it is reasonable for pair traders to avoid earnings report while holding pairs, sometimes conditions point to the obvious as described above, allowing probabilities to be in favor of the pair trader holding the position into earnings report. The favorability of this (RAI being Short) is diminished somewhat in these pre-reporting days with sell off (profit taking) already happening quite handily. My charts are posted at the TRADING forum at the thread Charts of Note. A fresh chart of this pair will be posted imminently for this pair, and I will post a link to it in my next post on this thread.
RAI Short PM Long Chart 5 Today the trade passed the break even point and soared well into positive gain territory, although closed off its best gain. One can be conservative and shave off some shares to lock in gain after the favorable reversal caused by the overstretched rubber band relieving pressure and the pair moving back toward the mean. But I generally find this unnecessary as the rubber band remains significantly stretched from the the mean. And with 3 layers, especially the latest one to be added so optimally positioned to take advantage of favorable movements of the pair, money can be made in this trade faster than the FED can print it. http://www.elitetrader.com/vb/showthread.php?s=&postid=3851371#post3851371