Pairs Trading Strategy Model

Discussion in 'Strategy Development' started by Neutral_Al, Sep 5, 2002.

  1. Bob111


    what about if amgn start move immidiately against you? (what usually happends))))you will need couple more sec to buy sec. leg. at this time you will be in about 0.5% loss. what you going to do in this situation? how big the difference between two stocks can be considered big enough? just trying to clarify few details..
    thank you!

    p.s. i agree about hist. correlations))) some of my pairs been good for couple years, but in last few month,as i mentioned somewhere before-trends start show up. trends in totally different directions for 20-30, even 50%....good stocks,same products....but...that why i stop hold them for more than one trading session.
    #41     Sep 20, 2002
  2. NDQnCA

    NDQnCA Guest

    did you ever get into the FNM/FRE position- i have been holding it, taking some heat, but i will NOT let the market and the sucker moves shake me out- in fact i have been making money trading the good moves (50-70 cents!!) to pay for holding the position (well, some of the cost) Its down to a 2 year low and the pair usually has a spread price of around 11 dollars. so, historically it is a very attractive buy with the very realistic probability of it reverting to the 11 average spread price. the only thing that concerns me is the worries about FNM and interest rate risk being higher than that for FRE- (the other worry is that MER is telling their clients to sell their FNM and buy into FRE- you can obviously see stronger buyers in FRE intraday than FNM- but you can make good money when FNM gaps up and prints it.) so FRE isn't getting whacked as hard as FNM- FNM makes crazy prints all day and has been hard to hold in a 1:1 ratio last week- i have switched from trading it 8 to 10 to 1:1 because if the market rebounds next week, which i feel we will get some upside retracement from the previous lows, then FNM will rebound more significantly to the upside than FRE. both stocks are in the EXACT same business and i don't think that FNM has significant risk over FRE- so it is stupid that people are selling FNM more heavily- i feel the pair will return to fair value and i've been holding it (3000 x 3000) when it reverts back to the historical mean, i will make a nice profit, but unitl then, i feel confident in holding it (3000 both) and also scalping the good moves on 1000 shares to make some decent gains. what are your thoughts (or anyone else) on this pair???
    #42     Sep 21, 2002
  3. nitro


    I have been trading FNM FRE on and off for a while. I always trade it in a ratio of 4 FNM for every 5 FRE, or 6:7. I always start with 400 and 500 shares respectively, and either take a profit intraday if it goes my way, or add to the position (in the same ratio) at key intervals if it doesn't go my way.

    I too noticed FRE becoming way out of line with FNM and couldn't resist taking a position in FNM/FRE late on Wed the 18th. It didn't go my way initially as I expected, so I decided to add near the close and take it home. The next day, FNM gapped down and FRE was slightly up - I was down $1200 on the open, which for me is a little more then I am willing to risk on a pair trade. I didn't panic and managed the position the best I could to try to contain the damage, as I will do sometimes, if at the point of extreme pain, I step back and realize that if I were looking at this trade afresh, I may take it in the same direction as the direction that I am currently in. Well, I managed to recoup about $400 on the trade, but then I saw that when FNM started to go up, FRE would be right there with it. I got out because I do not like to be in pair trade where I lose money on one side of the trade when both stocks are going down, and at best break even or lose money when both stocks are going up [or vice versa] - to me and my time frame on these things, that is the definitive answer - you are in a bad pair.

    The next day there was a terrific article in the WSJ about FNM and FRE. If you haven't already, I suggest you read it.

    I commend you for the balls and conviction that you have in staying with this spread with the size that you did on it. In fact, as I look at FNM/FRE now, I would be looking to get in again real soon - just not here.

    One last thing - I do not know what the ultimate answer to holding a pair is in relation to risk. For example, everything in my being says that this spread has to come back in line, but I feel that the risk of it staying away from par is just too great at this point. On the other hand, I know of an example where Bob Bright held MRK/LLY as it went against him, continued to add to it with the tenacity of a Bullmastiff until he was down $2,000,000 on the pair, only to make $4,000,000 in one day when LLY cratered - but only month(s) later. I do not have this kind of staying power or this much risk tolerance... :(

    #43     Sep 22, 2002
  4. Hi all,

    I did open a position on 9/20/02 at the open R=1.104. So far it is a loosing trade. I decided to hold it over the weekend. The question is what do you do next?
    a) Do you hold it till it becomes a winner? If you do, do you add to your position? If you do, when? And how do you know if it becomes a winner at all?
    b) What is the risk of holding this position? Does it become greater or smaller as the pair moves against you? Is there a way to calculate risk/reward ratio for a pair of stocks?
    c) How do you decide when to exit the position? Is is a time parameter, max allowed loss, technical indicators?

    Please let me know your thoughts. These issues are the most difficult ones. If we could solve them we would be on our way to a pretty good trading system.

    #44     Sep 22, 2002
  5. Bob111


    from my expirience-the longer you hold-greater risk you take-it basically obvious. most of the time-it not worth it. i would say if it did not go in you direction in monday-close it @ close. i know, there is a great correlation on those stocks and it very unusual to see such difference but......BW-why YOU don't have plan, when you enter into this trade? you MUST have it. you must know-how much risk you willing to take, how much profit you are looking for and so on..or you just enter, because somebody else enter?

    Good luck!
    #45     Sep 22, 2002
  6. nitro


    These are extremely difficult questions and have no answer that is too particular to statistical arbritrage. If you are thinking that pairs trading violates many of the traditional cliches of trading maxims, I agree. I often feel, after having done hundreds of pair trades [if not thousands now] that the ONLY holding period for a pair like FNM/FRE is until it becomes profitable or forever, whichever comes first, while adding to the position as the the pair goes against you. This is so contrary to intuition, but it is probably the only way to trade pairs on the larger time frame [I have not thought about the mathematics of the R/R aspects of trading this way - it is just an observation that I have made countless of times when I got out of a pair at extreme pain, only to have been vindicated days later - and watching traders like Bob Bright do these things...]

    The problem is that you need balls from Chicago to New York to stay in this slaughter...It is for this reason that the best traders seem to blow their accounts once or twice in their trading lives...


    #46     Sep 22, 2002
  7. soon it will be 4 fre to 5 fnm lol
    #47     Sep 22, 2002
  8. NDQnCA

    NDQnCA Guest

    yeah- lol FNM is getting whacked.... but this ugly bitch of a pair will make me money- but hard to hold.......

    anyways, what do you all think of trying to set up a forum for pairs trading or if we all were to do a pairs trading chat sometime after the close and we could all talk strategy???
    #48     Sep 22, 2002
  9. I've never done any pairs trading but it sounds interesting, particularly in this market. I am struck by one thing however. Pairs trades seem to be the reverse of the normal hedge strategy of long/short, because a long/short trader would be long the stronger stock and short the weaker. A pairs trader would seemingly be in the opposite position, looking for a reversion. Am I missing something?

    A good example might be JPM/WFC. One crap bank, one solid bank. I haven't looked at the spread but it must be wider than normal by a long shot. Certainly, I would be nervous about this trade, so nervous that I might want to be short JPM, long WFC. So how do you factor this sort of analysis in? Or is it irrelevant?
    #49     Sep 23, 2002
  10. Hi AAA,
    Pairs trading and long/short strategy are both hedging strategies. If you trade/invest primarily based on FA, then you have a long/short spread (long a stock with good fundamentals, short the stock with poor fundamentals). Pairs trading, on the other hand, is a form of statistical arbitrage where a trader capitalizes on price action inefficiencies in a pair of stocks which are manifested by divergence from a historical mean. It is based on statistics, math, and TA, less so (if at all) on FA.

    Historical correlation and s/w predictable price action gives me as much comfort as being long a good stock and short the bad one gives comfort to you.

    I just finished testing several combinations for entry points. The best results are produced by 3 SD from the 6mo mean with 30>RSI>70 for 2 sessions. Ex: D/ED. This pair has 86.475% probability to converge towards the mean within 2 months.

    By the way, I found FNM/FRE recommended for today at the open in my Sunday update from Gee, I guess I am doing something right. The question still remains, however: How come I opened a position last week and have been loosing for 2 days, and these guys recommended it today? I guess their model told them to wait on Thursday and Friday.
    It's all about entry and exit points.

    Does anyone have any experience with a combination of indicators for entry/exit points with good results?
    Any thought is appreciated. I'll run statistics on all of them.

    #50     Sep 23, 2002