Pairs Trade

Discussion in 'Strategy Development' started by bentedges, Jul 21, 2009.

  1. For those among you who trade pairs and like a little stat arb action, things have gotten a little out of whack lately as plain vanilla funds and some of the hedgies fall in love with technology stocks. Looking at the YTD returns for the S&P500 and the Nasdaq 100, we can see quite a disparity has developed. The Naz has roared, and while the SPX has performed decently off the March lows, the divergence between the two has created opportunity.

    AAPL reported earnings and gave their usual conservative guidance, which of course, the momentum junkies took to mean they will blow their numbers out next quarter/year. The QQQQ's were trading up sharply after hours on this, with the SPY giving a slightly more muted reaction.

    WITHOUT taking the after-hours into account, we find the SPY/QQQQ pair trading at a bit more than -2.0 standard deviations from the mean. The differential ratio went out at $2.5031 (SPY = 95.57, QQQQ = 38.18)...thus, the opportunity. We should see a bit further expansion in this pair in the morning, and it creates a nice opportunity because not only are we extended from the 'norm', but we also are able to put on a trade completely without stock-specific risk.

    My idea then is pretty simple: Short the QQQQ and buy the SPY on a 2.5 to 1.0 ratio (volatility-adjusted.) Cover the trade when you get at/near $2.60 on the ratio.

    Full disclosure: Put this trade on today and looking to put on more layer(s) should it move against me. These particular type of opportunities don't often present themselves; the risk is much more muted in this type of pair and merits putting on some decent size should it move further (bear in mind, it will take longer than a day, mkay?)

    For those who haven't a clue of what I am speaking, and wish to tell me what an idiot I am because tech stocks are great and AAPL is changing the world, save the flames. Go try to catch your momentum in GOOG, AAPL or whatever and let the results speak for themselves over the next 1-2 months.

    And congrats if you can catch the momentum that currently exists, btw...we all know this will end ugly once a decent correction sets in...will you be able to find a chair?