i apologize for the slight but c'mon, people on here use expletives far worse than a euphemism for "talking shit." try not to be so sensitive what "market neutral funds" are you referring to? surely not hedge funds which are rarely if ever even close to neutral and are usually in so many different financial instruments, be it swaps or other derivatives, time bound futures or options against stocks, and who knows what else. usually, higher risk than other funds and they got killed last year but hedge funds do not have just a pair portfolio. even "good" pairs had a tough time last year as multi year correlations/cointegrations were blown out by 100+ year companies evaporating into the financial meltdown vacuum. as for my frustration, on these strategy forums, i LIKE to think that we are at least trying to offer up something that aspiring traders can use and when i see people lambasting a system that i am certain CAN work as something that has no value, i feel obligated to counter their attacks. you seem to believe otherwise based on your friend's experience and that is your belief but it does not necessarily have to be correct either as you have a small sample or perhaps they were using a different pairs technique. absolutely, for sure, one can make money using directional plays and in the fall, tight stop, direction plays may have been the way to go to try to capitalize on the wack volatility. to me, this takes a little more skill, confidence and discipline and the newbie pair trader can trade without blowing up and eventually, reach the level where they can make coin doing that too by slowly learning the market's behaviors. at least 43 ways to skin a cat and IMO pair trading is one of them and a great one for beginners.
A well considered pair portfolio can reduce systemic risk much more than a poorly created portfolio. The point I was trying to make was that I don't believe you can neutralize systemic risk completely. You are always exposed. Most people who are new to pairs trading assume that they have removed the risk by being 'market-neutral'. It just isn't true. Very true. Beta is just one of the measures that many people use. Fundamentals do often come into play. I was just giving a simple example of how some people weight their portfolios and how it isn't fool-proof. Look at financials in the last year. I don't have any off hand, but I have no doubt that there were those who had beta's below one that jumped above 1 when the floor fell out. Financials lead the way down, so they were the most volatile. And the betas changed very, very quickly. Betas change because betas are NOT constant. You have to estimate your betas and assume stationarity going forward with the trade. So you may estimate beta using the last 4 months of data for a trade that will last the next week. But if you estimate beta using the last 4 months and have a pair trade that lasts 3 months ... there is a good chance that the beta you are weighted with no longer applies, which exposes you to systemic risk.
look guys, i like greek letters myself, but i think you're over-engineering this . . . let's assume the max holding period for a given pair is 10-15 days . . . that would be the time stop . .. if i'm trading a huge divergence from the ratio mean, assuming the mean exists and it's stable, and the pair is showing high correlation and/or cointegration . . . that's the specific concept we should be thinking about here . . . i think the beta suff is for portfolios . .. if you can give specific examples of how a pairs trade breaks down, and why, that's good . . . otherwise it's a bit theoretical one friend who didn't make it in pairs trading is not strong enough evidence. ernest chan, who has a ph.d. in quantum mechanics from princeton, has been doing this successfully . . . that's fairly strong evidence for me . . . jonnysharp is doing it successfully, as can be seen from his journal, that's fairly strong evidence for me . .. so people have really thought through this stuff . . . it's not like they're a bunch of idiots, who bought the crap sold to them by third-rate salesmen about market-neutral strategies . . no offense, but, you know, as long as there is emotional discipline, and, above all, peace of the mind, i think we're ok
Corey, thanks for the beta explanation, i had interpreted what you said to mean that almost all stocks went up and stayed over 1. as i said, your posts are usually well thought out so i should have known better. last fall, whilst i would usually check the changeable fundamentals monthly, i SHOULD have been checking them weekly if not more often but then, it is the first time i, and probably most people young enough to see had seen such sustained, unbelievable volatility. when volatility is more mellow, like now, the beta difference is negated by the probability that mean reversion will occur "soon" or for those that layer into pairs with longer time frames, the undervalued stock catching up with the overvalued. but yes, if the betas are way off, like your longs avg. 2 and shorts .5, you are exposing yourself to systematic risk.
great point peace of mind gives rise to objectivity which is so helpful in making trading decisions based upon what the market is giving us in the moment.
Another suggestion would be to compute the average holding time in which the given pair reverted back to the mean. For example, for one pair, the average holding period might be 12 days. Another pair, 10 days. Still another pair, 7 days.
while we are discussing the technical aspects, it's also very important to be able to see the bigger picture. masakatsu ("true victory") is associated with the male element of creation; agatsu ("self-victory") is associated with the female element; joined together harmoniously, they represent katsuhayabi ("vicotry right here, right now!"), an ideal state of perfection and completion.
Optioncoach hit hit it on the head. It sounds like people who say they know someone who lost his shirt trading pairs are still looking for the one single magical strategy that has no losses.. All strategies have losses and mitigating them through proper risk management is 90 % of the battle. And that includes proper position size management. If your trading pairs with 5 % a position (2.5% per leg) you should be ok even if one leg was halted and opened at zero... Each trade in and of itself should really be insignificant to the portfolio, but when added together is when your edge should shine... Cheers.. Nick