I use the Bloomberg to calculate currency and volatility-adjusted hedge ratios. That's what made it so popular for bond traders in the 1980's.
Thanks for the reply bone and Dave. Does the bloomberg help in the ratios of stocks as well? In addition, can someone suggest another crude method of estimating the hedges since I can't afford a Bloomberg Term.
Try iVolatility http://www.ivolatility.com/options.j?ticker=spy&R=0&top_lookup__is__sent=1 For example, using SPY above, Historical Volatility 10 days is 17.97%. So, 0.1797 / Sqrt(250 days in a year) = 1.137% in a day Multiply this times the price of SPY, $100.24, and you get a 1 standard deviation move for SPY of $1.14 per day. Do the same for QQQ, and you'll see the ratio is approximately 2:1, that is, SPY is about twice as volatile as the QQQ, on a dollar balanced basis. If you are looking at a longer timeframe for trading, consider using Historical Volatility for a 30 day period. Also, HV's will change over time, so be sure to update your ratios periodically.
Let me see if I get this straight, you'd want to establish a ratio so that a 'typical' move by one instrument approximates the other leg. So if abc moves on avg 30 cents per 10 minutes, you'd want to extablish an opposite hegde approx equal to that range on a single unit. Example : pair abc with xyz given xyz has 10 cents avg true range, you' want to hedge abc with 300 abc thereby equalizing their true range. This is entirely diff. that $ equalizing, more like vol equalizing. Bone posted this a while ago -use dv01 to establish nob, bund bobl, fob ratios not $ equivalent. Am I correct? Thanks again guys. Last question, given the prevalence of auto spreader software such as TT and other prop systems, I feel that someone equpped with a mouse point and click Jtrader would stand little chance of putting on spreads on a scalp basis since it would be no match for those systems. I've tried to leg into these spreads and always get bad prices, even though I think I am reasonbly fast, probably no match against the auto spreaders,etc. I feel that my only chance is to lenghten the spread trade fractal i.e. > 10-40 minutes -play the tide not the ripples so to speak. Does that assumption make sense? Thanks again
The descision/calculation of what ratio to use is intimitaly related to whether the pair is out of whack or not in the given timeframe. nitro
If you are (intraday) spread trading something that does not have the uptick rule, e.g., SPY/QQQ, then your disadvantage is not great. If you are, e.g., equities, your best bet is to concentrate on 2 to 5 pairs at most and get a one month conversion on each side and pray they move enough to justify the added cost of the conversions. This, IMHO, is the achilles heal of this strategy for equities... nitro
Correct me if I am wrong - and I'm sure that somebody will - but who is in back of this fairly recent emphasis on pairs trading? Isn't it firms that earn a large part of their revenue from commissions? The very same folks who brought you the strategy of scalping for fractions circa 1998-2000, whereby a zillion poor suckers enjoyed all the benefits of carpel tunnel syndrome while spending 20K a month in fees for their "employers"? But hey, you got to be a "professional" with a license(!) to trade there, so they MUST know something you don't, right? Anyone get the picture?
Essentially yes, you'd like to equalize these to 30 minute, 60 minute, or whatever movements are in line with your timeframe. The profitability of this method comes with the timing of each ones move. That is to say, statistically, these two tickers have demonstrated historically a greater probability of moving the same *dollar* amount in a 30, 60, or X minute timeframe, if you have balanced the pairs as we are discussing. And, yes, I agree that this is really a volatility balancing, rather than a dollar balancing. Going to nitro's statement, when the spread gets out of whack, or in other words, when stock A has moved, and you are statistically confident that stock B will follow (or stock A will return to it's original state), you could adjust your ratios. However, I'm less sure about whether it'll be stock B or stock A that will move to bring it back in line. In some cases, if you are trading pairs correlated with the SPoos, then say, stock A has moved to follow a selloff in the SPoos. It's highly likely that stock B will follow rather than stock A returning, so it may make sense to either sell more stock B or buy less stock A. As to your statement about automation, I scalp pairs both manually and using automation software. As with any automated program, it's not magic, and you should be able to do the exact same trade by hand. The automation just let's you do it faster and trade more of them at once. Where I used to get caught up, especially in the shorter timeframes, is not with slippage, but just with figuring my entry price and exit price. If you figure that you will cross the market, i.e. hit the bid and lift the offer to get into the spread, you should look at that price instead of the last print of the two stocks. This can be significantly different. Trade your spread based on that, and you'll find you have much better entries and exits.
TruthTeller, I'm sorry if these recent posts are coming across wrong. This thread's emphasis was based more on swingtrading pairs like FRE:FNM and the like. This clearly does not fit the prop model. I am the one who has suggested that I personally trade pairs on a shorter term. I'm just relating my experience, which hopefully translates to others on a longer term. I wouldn't advocate that anyone else trade this way. Furthermore, I hope it doesn't sound like I'm pushing an agenda, because I am not. It's my hope that discussing things like entry pricing and the like will help traders doing pairs on any timeframe. But hey, let's say that someone figures out a way to net 3 cents a trade after deducting 1 cent per share for commission. Trading four pairs 200:200 making 35 cents per day can easily be done in an Interactive Brokers account. That only amounts to $70 per day net to the trader. Make that 400:400 and it's $140 per day. Realistically, with a $25K account to satisfy pattern daytrader requirements, margin will give you $100K to work with. Conceivably, that trader could do 1000:1000 and average about $350 per day net (actually more because of IB's reduced pricing for larger orders). Not huge, but probably better than most traders are doing. There's no prop trading agenda there, as you probably don't want to get much bigger in some less liquid pairs. So, do this from an Interactive Brokers account. But, I agree, like scalping, this is a very busy way to make a living. And the costs are higher than many other trading methods. Each person should evaluate this, or any other approach for that matter, based on time, costs, risks, and trading style preference. It's clearly not for everyone, and clearly doesn't require a Series 7 or prop backing.