Pair Trading Strategy Journal

El OchoCinco · Mar 28, 2009

I had been trading pairs on my own apart from this thread and noticed it recently. Thought I would throw my two cents in since everyone is sharing ideas. One thing that has helped me in timing entries and exits (I do not use the software discussed here) is when I have a good pair with good correlation, I programmed Thinkorswim to chart the ratio of the pair and then I slapped a long-term Bollinger Band indicator over it with about 60 day moving average and plus or minus 2 standard deviations.

When the ratio goes outside the bands I fade the pair and it has worked out well for me. (Do not have statistics but on actual trades and backtested trades it continues to work well.

The primary key is having a good list of pairs which is the research part. This is where the individual skill really comes in and what factors you use to keep or disregard a pair. I cannot scan so I manually check my pairs for signals which does not take that long but I found this to work well. Took a while to program it but I get a great visual when to enter and when to exit if you are familiar with BBs

NKNY · Mar 28, 2009

Quote from waltbx:

Here is what I did. I'm grateful for the guys who know much more than I do for sharing. I learned from them, especially Jonny.

I have read each and every one of the posts listed in this journal, and copied notes into a word processer to use as a training guide. I'm treating it as a business and am being very serious about it. I ask questions on the forum after I have worked unsuccessfully to find my answer.

My Pair Trade Finder settings are the default settings, except my trade size setting is $2500 (Long+Short = $5000 total). My account size was a little larger than $25K now up to almost $30K, and I use the margin provided by my broker, IB. I have my layers set to 2.00, 2.20, 2,40, etc.

I studied the graphs of the trades Jonny put on, and studied his loosers. What was the commonality in the big losses? What did the graphs show that was in common in the losses?

To find Jonny's spreadsheet of his trades, go through the posts to find where he posted his Excel spreadsheet. Study his trades, and look up the graphs in Pair Trade Finder. As Jonny posts his trades in this Journal, I put each of them in the spreadsheet. I study the losses.

Some thoughts on what pairs to choose. Some people on this thread have said they aren't concerned much about the past profit history of specific pairs. I don't agree. (Keep in mind that many of them have much more experience than I have, and you should weigh their advice heavier than mine.) It is my belief that if we are to look historically at correlation of stocks in a pair, it is equally valid to look at profit history of the pair. After all, profit is why I'm in the game. If I have a choice between a pair averaging $35 profit over the past year, and one averaging $200, I'll choose the $200 pair. So I load my stocks, then PT finds all the pairs, and I choose the ones averaging $200 or more and with a correlation of 60% or better. My trade size is $2500 so if you go with a $10,000 trade size, you would look for pairs with an average profit 4x larger, or $800 or more. I don't tie my money up with smaller potential profit.

When I discovered what I think is the key to knowing if a good pair will bring a profit today, I was ecstatic. I was looking at Jonny's trades and studying the graphs. You must do this. It will sink in better if you do this yourself, I believe. I saw the correlation between his loosing trades and the graph for those pairs. Most of them were trending pairs.

Remember, that to be profitable, the ratio must drop below where it is today (that is if the ratio is above the mean today -- or go up if below the mean). And remember too, that this is called Mean Reversion pair trading. We look for pairs with ratios that have diverged from the mean, and we are expecting the ratio to revert back to the mean. But if, while we wait, the ratio continues to rise, over days it will drag the mean up with it. Losses occur when the daily ratio finally meets the mean, but does it above the entry ratio. So, the key is to study the Ratio Chart and pass on those pairs where the ratios have little chance of meeting the Mean Average line at a point where profit can be made. ie: don't trade pairs with strong trending graphs. Don't bother with "iffy" pairs.

Do not fail to check for news. Any news that affects one stock in the pair, but not the other is problematic. Earning's reports coming in the next two weeks are a possible problem.

I use a spread sheet to calculate an estimated profit % using the present ratio and my conservative estimate of where the ratio will be when it meets the Mean, determined from the ratio chart in PT. I choose only those pairs with an potential profit of 5% or more. I use this formula: (Expected ratio less today's ratio) / (today's ratio) x 0.5 as a percentage. This has been VERY helpful in making choices. Some pairs that have enter-the-trade signals have had potentials of 10%, some less than 1%.

Before I get a signal to close, I'll set a stop loss to protect profits if one side is showing good profit. I'd rather take a good present profit, than risk losing it for possible future gain. Perhaps I'm wrong. When I get a signal to close the trade, I'll close out the losing side, but let the profitable side run, keeping a trailing stop loss to protect my profits.

Jonny spends an hour studying the pairs, and trades once a day, at closing. I'm excited and having fun, so I spend my morning (I'm on the west coast USA) at the computer studying the trades and playing the "game." Personal choice. Eventually, I'll probably shift to what Jonny is doing, and do other things with my day.

I haven't tried to factor RSI into the mix. Maybe someone with experience can tell me how RSI has been important to them. I haven't factored in spread either. I'd guess that if the spread were decreasing, that would be a good sign.

Works for me. So far.

Walt B
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Thanks for your post and contribution walt. Very insightful

Nick

yobo · Mar 29, 2009

Quote from jonnysharp:

walt, great to see your've done your work, studied my trades, taken it a step further and thought outside the box, all the qualities of a great trader. you've made a few good points that have made me think.
with regards to a pair backtesting well, its a valid argument you present and I agree with, however remember to make sure with a backtest the pair didn't generate the majority of its profit from one trade, rather even dispersed across all trades. i like you point with measureing the % difference between ratio and avg ratio, a step further would be to divide this number by the pair volatility, for eg a 5% divergence on a pair with volatility of 2% is more significant of pair with a 8% divergence with volatility of 5%, so divergence % relative to volatility %. maybe we can mention to them to incorporate this reading into the console. I don't use the RSI too much anymore, I like a strong divergence, Ive actually been using the spread chart more, like to see it a 50day highs/lows and fade that direction if the signal coincides. glad ive been of help to you and thanks for sharing your method.
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Oh man, now you are beginning to scare me. Not just you johnny but everyone else too with all this analisys. This divided by that and that divided by this. Oh man let's keep this simple.

Buy low sell high. If you are gonna look at one chart for a decision look at the pair ratio chart and how it behaves around the mean. If you have a wavy pattern, awesome, if not and the ratio looks like it has a strong trend stay away or just trade the trend.

Thousands of trades later, I finally learned. This is a simple game to play. Just have to keep the rules simple.

Also much easier on the psycie.

Appleseed · Mar 29, 2009

Quote from waltbx:

I haven't counted my pairs before and did today. I have about 250 pairs, about 550 stocks, and about 36 sectors if I ignore the sectors with only 2 or 3 stocks. The number of pairs per sector varies from 1 or 2 to 40 pairs in Asset Management, which is a new sector I'm exploring. Each pair has a good profit history, others I ignore.

Walt B
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Is that sectors or industries?
cheers
john

zeke3079 · Mar 30, 2009

To anyone actively using pairs strategy, how do you guys go about handling dividends, in regards to the short end of the pair?

waltbx · Mar 30, 2009

Quote from Appleseed:

Is that sectors or industries?
cheers
john
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Yup, John, I should have said about 36 industries, not sectors.

Walt B

waltbx · Mar 30, 2009

Quote from jonnysharp:

walt, great to see your've done your work, studied my trades, taken it a step further and thought outside the box, all the qualities of a great trader. you've made a few good points that have made me think.

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Yah, well, thanks, but I took some losses soon after my post. "Pride goeth before a fall."

My profit is down to $3200. I'm not complaining, but thought I'd be straight with you guys. One large loss was a short on BARC (Barclay), a financial. The day after I sold it short, good news came out, and I cut my loss at $800 (on $2500 investment). I learned to stay away from financials, as someone posted earlier on this thresd. I ignored the advice. Financials have too much possibility for individual stocks to issue good or bad news in this climate.

Foolish mistake. But I learned something.

Thanks for the nice remarks. I'm a little gun shy now.

Walt B

waltbx · Mar 30, 2009

Quote from jonnysharp:

with regards to a pair backtesting well, its a valid argument you present and I agree with, however remember to make sure with a backtest the pair didn't generate the majority of its profit from one trade, rather even dispersed across all trades. i like your point with measureing the % difference between ratio and avg ratio, a step further would be to divide this number by the pair volatility, for eg a 5% divergence on a pair with volatility of 2% is more significant of pair with a 8% divergence with volatility of 5%, so divergence % relative to volatility %. maybe we can mention to them to incorporate this reading into the console. I don't use the RSI too much anymore, I like a strong divergence, Ive actually been using the spread chart more, like to see it a 50day highs/lows and fade that direction if the signal coincides. glad ive been of help to you and thanks for sharing your method.
More...

Thanks for this, Jonny. I'll try to put it into practice. I'll add it to by worksheet spreadsheet.

I don't understand what you mean by "fade that direction."

Also Saico's tip about avoiding pairs that resist going into the top 1/3. "...that resists at least in the upper 3rd of its recent 150 days trading range seems to be optimal. " But Saico, I'm not clear on what you mean by the top 1/3 of the recent 150 days trading range. Could you be more specific?

Walt B

waltbx · Mar 30, 2009

Quote from waltbx:

One large loss was a short on BARC (Barclay), a financial. The day after I sold it short, good news came out, and I cut my loss at $800 (on $2500 investment). I learned to stay away from financials, as someone posted earlier on this thresd. I ignored the advice. Financials have too much possibility for individual stocks to issue good or bad news in this climate.

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Stock was actually Barclay BCS.

WB

saico · Mar 30, 2009

Quote from waltbx:

Thanks for this, Jonny. I'll try to put it into practice. I'll add it to by worksheet spreadsheet.

I don't understand what you mean by "fade that direction."

Also Saico's tip about avoiding pairs that resist going into the top 1/3. "...that resists at least in the upper 3rd of its recent 150 days trading range seems to be optimal. " But Saico, I'm not clear on what you mean by the top 1/3 of the recent 150 days trading range. Could you be more specific?

Walt B
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Hi Walt,

I was actually refering to a kind of overbought/oversold scenario. But found out over the weekend that this has no validation for the ratio chart. Sorry for making things that complicated.

But nevertheless I did another major change. I scanned my sectors completely new and filtered pairs as you mentioned couple days ago. Here are my filter criterias.

- I only took pairs with stocks that are in the same sector. ( 1 small excemption was some pairs with tech stocks.)

- Average correlation atleast 65%

- Minimum profit average per trade 800 USD (Assuming 10k per side)

- Consistent profitable trades around the profit average. Very view and small losers (1-2) during the backtest period of 365 days.

- Stock price >5 USD.

The result was that I got around 50 top high quality pairs. Thats more than enough for me and my account.

By the way I dont mind sharing these pairs even its been kinda hard work to filter them out. But I owe this thread a lot and therefore I dont care to give something back. All who are interested may pm me.

Saico