Professional Documents
Culture Documents
Table of Content
Disclaimer ........................................................................................................................................ 4 What Is Spread Trading? .................................................................................................................. 6 Why Trade Spreads? ........................................................................................................................ 7 The Art of Becoming a Better Trader ................................................................................................ 9 Spread Trading Mechanics ............................................................................................................. 11 Types of Spreads ............................................................................................................................ 13 Choosing a Spread ......................................................................................................................... 14 Statistical Methods ....................................................................................... 15 Non-Statistical Methods .................................................................................. 24 1. Trading on Bottom-Up and Top-Down Analysis (Value Investing) .............................. 25 2. Merger Arbitrage .................................................................................... 26 3. Liquidity Gap Spreads .............................................................................. 28 4. Trading the News .................................................................................... 31 5. Day Trading Spreads ................................................................................ 43 6. Dual-Class Shares ................................................................................... 46 7. Patterns .............................................................................................. 47 Combining Different Methods ........................................................................................................ 48 Execution Technology ..................................................................................................................... 50 Risk Management .......................................................................................................................... 52 Exit Price ........................................................................................................................................ 54 Special Topics ................................................................................................................................ 56 What Else Can We Trade Against This? ................................................................ 56 How to Use a Spread to Form a Directional Opinion .................................................. 57 Creating Signals ........................................................................................... 59 Market Versus Predictive Spread 1 .................................................................. 59 Volatility Spread 2...................................................................................... 60 Consumer Sentiment Spread ......................................................................... 61 Interest Rate Spread ................................................................................... 62 Gold Spread ............................................................................................. 63 Creating Your Signal ................................................................................... 64 Trading Statistical Spreads Around Earnings Dates ................................................... 66
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Dividends .................................................................................................. 67 Carry Costs................................................................................................. 68 Contango/Backwardation ............................................................................... 69 Trading Options ........................................................................................... 71 Creating a Playbook ...................................................................................... 75 Conclusion ..................................................................................................................................... 78 Additional Material ......................................................................................................................... 79 Join the One Percent ..................................................................................... 80 The Big Spread Debate ................................................................................... 81 Trading Insider Purchases ............................................................................... 83 I Wish I Had Learned to Trade This First ................................................................ 85 Darwin the Trader ......................................................................................... 88 Learn To Trade Like a Math Geek ....................................................................... 90 Spread Trading and Takeovers .......................................................................... 91 Taxes ....................................................................................................... 92
Disclaimer Disclaimer
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The Company is not a registered broker-dealer and does not endorse or recommend the services of any brokerage company. The brokerage company you select is solely responsible for its services to you.
It maintains market neutrality, reducing exposure to the overall market direction. It reduces sector and industry risk, depending on the short security chosen. It reflects the differential economics by removing factors outside the scope of the trade (market noise). It improves your ability to compare and analyze. It is self-funding because you can use the short-sale returns to buy the long position (subject to margin requirements).
Reduced risk can reduce profit potential. Further divergence between the legs can lead to a loss on both legs of the trade. You may face increased exposure to short risk on the short leg, with the potential for a short squeeze. Few brokers offer spread-trading capabilities (e.g., Interactive Brokers combo trades), making it complicated to execute and track.
And thats not all. Because the concept of cointegration, which is central to spread trading, is a measure of the statistical elastic force between two securities (more on that later), we can use spread trading to implement more effectively directional or volatility trading strategies.
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We can even create signals using spreads to try to predict the direction of the market or sector and so forth. For all these reasons, mastering spread trading will elevate a trader and investor to a higher performance level.
The Art of Becoming a Better Trader The Art of Becoming a Better Trader
When I traded single-stock derivatives at D. E. Shaw, observing my boss trade S&P options fascinated me. He made money consistently, though he took little risk. He was a trading magician. He knew his options market, especially the S&P, and he knew how to trade spreads. He constantly traded in and out, squeezing juice out of the lemon. The lemon never ran out of juice! It was a wonderful thing a winning trading method. He started his career trading options for OConnor & Associates and then worked for Swiss Bank before joining D. E. Shaw. Both of these were great trading houses at the time. Most of the best traders I have met trade spreads. They spread different options, stocks versus stocks, indices, stocks against indices, and the like. The number of combinations is endless. Spread traders are good at identifying pockets of value among the securities they trade, and they rotate their inventory to take advantage of these discrepancies with no net increase in market exposure. The Twitter financial stream is populated with one-dimensional risk-augmenting trading ideas. Most of these ideas are actionable in isolation, but they are not suited for traders seeking to compound wealth by deploying capital optimally with a constant risk profile. The art of becoming a much better trader requires gaining exposure to spread trading. When you start looking at the trading world from the point of view of trading one security against another, you will:
Analyze the economics of both legs. Hone your ability to identify value within the set. Remove some of the market noise from the equation.
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Establish a better basis for comparison and analysis. Investigate new areas for exploration. Understand the meaning of hedge. Think in terms of capital efficiency and velocity. Discover powerful trading patterns not visible using traditional charting methods.
If you are still skeptical, then check out Charlie DiFrancescas trading video. If I had to recommend just one trading video, this video would be it. He filmed this video in 1989, and it is a must-watch for all traders. Here is a cool example of how we recently applied Charlie Ds advice. After the market closed on June 28, 2012, this tweet from Aris David caught my attention: FYI, Europe covered before the close FTSE last minute rally $EWU Our signal (more on building your own signal later on) had a super strong buy signal going into the close of the U.S. market, and we were waiting for a dip to buy. After the market closed at 4 p.m., the S&P futures went down seven points, and we decided to buy a bigger futures position based on our signal and Aris s information. We thought someone knew something about Europe given how the FTSE closed, and the S&P selloff presented an attractive opportunity. We had more conviction, so we committed. That is what spread trading is for us. It means trading the relationships not only the statistical relationships between stocks, but information against information, a stock price against its intrinsic value, and price against news. Spread trading is about exploiting two levels of potential energy and their relationship. The next day, the market went up about 2%. Someone knew something, and we exploited it.
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If ABC is trading at $20 and XYZ is trading at $10, then you need to compensate by trading two shares of XYZ for every one share of ABC. Another way to think about this is that if you want $10,000 exposure on each stock, you need to buy 500 shares of ABC and sell 1,000 shares of XYZ (ratio of 1 to 2). The concept of notional exposure is also important for calculating profit (or loss). Suppose you buy the spread 1 * ABC 2 * XYZ at a level of 0. To get to my $10,000 exposure on each stock (or leg of the spread), you buy 500 spreads, which means you buy 500 shares of ABC and sell 1,000 shares XYZ.
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Now assume you are right and ABC increases to $30 while XYZ goes up to $11. Your spread is now trading at $8 = 1 * $30 2 * $11. If you close the position, your profit is $8 per spread * 500 spreads = $4,000. You could also calculate that you made $5,000 on your long ABC position, but you lost $1,000 on your short XYZ position for a net profit of $4,000. But what is your return on capital? Typically, we look at return on long (or short) capital, which is a more conservative return number. In this case, we started with $10,000 exposure on each leg of the trade. Total profit was $4,000. Return on long (or short) exposure is $4,000 / $10,000 = 40%. You could also consider return on leveraged capital, which varies depending on the margin requirements you face. If you put up 30% margin on each leg, you will need to have $6,000 cash in the account to do this trade, so your return is $4,000 / $6,000 = 67%. Some brokers allow you to trade spreads easily through multi-leg orders. Interactive Brokers, for example, has a combination order feature that allows you to trade both legs of a spread with one order. Please see our video about Interactive Brokers combo orders for detailed instructions. If your broker does not have this feature, you will need to track the spread levels manually using a spreadsheet. Once the spread reaches your desired entry (or exit) point, you enter an order for each leg of the spread.
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Statistical Methods
Statistical-methods traders use mathematical approaches to first identify spreads that trade around a mean and then find opportunities to trade when these spreads have diverged from this historical mean. In these cases, traders must select spreads that are likely to revert to their historical means. Identifying these spreads involves statistical analysis. Below is a description of the theory behind statistical analysis. If you find some of the theory challenging or confusing, don t worry. Our tools do most of the hard work for you. Stock prices are typically modeled as Brownian motion (random walk), where the price in each period is a function of the price in the prior period, Y (t 1); the trend rate of increase, B; and an error term that has an expected value of 0: Y(t) = B + Y(t - 1) + e(t) Each leg of the spread can be modeled in this way. Figures 2 and 3 show the movement of several examples of pairs.
120 100 80 60 40 20 0 -20 120 100 80 60 40 20 0 -20
Figure 2. Pair 1
Figure 3. Pair 2
In both graphs, the two stocks diverge from each other at points and converge at other points. The goal of the statistical analysis is to determine whether it is likely that the two stocks will converge if they diverge.
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F = -kx Stock B
Stock A
Figure 4. Spring Mean-Reversion Model: Stretched
Stock B
Stock A
Figure 5. Spring Mean-Reversion Model: Reverting
Again, correlation is sometimes confused with cointegration; however, the statistical cointegration does not necessarily imply a high correlation. Correlation is a measure of how two securities move in relation to one another. A high correlation implies that
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the two stocks move in synchrony over the short term but does not guarantee that the two divergent stocks will revert to the mean in the long term. This distinction between correlation and cointegration was demonstrated by Dr. Ernest P. Chan.1 Robert F. Engle and Clive W. J. Granger proposed a two-step approach to calculating cointegration: If each individual stock price series exhibits a random walk (nonstationary) but a linear combination of them is stationary, then they are said to be cointegrated.2 Below we give the steps for calculating cointegration: First step: Determine the time frame you are going to use for the analysis (more on this later). You may want to look at a few different time frames, such as one year, two years, or five years. Perform ordinary least squares (OLS) regression on the chosen time series equation below to estimate the beta. In the equation, Y(t) is the price of one security at time t (dependent variable), and X(t) is the price of the other security at time t (independent variable). Once you know the beta, use the known values of Y(t) and X(t) to get the residuals (spreads).
Second step: Test the residuals for stationarity using the augmented Dickey-Fuller (ADF) unit root test.3 Mathematical programs such as MATLAB or R have functions to calculate the ADF test statistic. The ADF test looks at the following equation:
Ernest P. Chan, Cointegration Is Not the Same as Correlation, Trading Markets (blog), November 13, 2006, http://www.tradingmarkets.com/.site/stocks/commentary/quantitative_trading/ Cointegration-is-not-the-same-as-correlation.cfm. 2 Robert F. Engle and Clive W. J. Granger, Co-integration and Error Correction: Representation, Estimation, and Testing, Econometrica 55(2) (1987): 251-276. 3 Said E. Said and David A. Dickey, Testing for Unit Roots in Autoregressive Moving Average Models of Unknown Order, Biometrika 71 (1984): 599-607.
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The ADF looks at the mean reverting co-efficient, gamma. The test uses the null hypothesis, gamma equal to zero, and the alternative hypothesis, gamma less than zero. The result is a confidence level that we can reject the null hypothesis in favor of the alternative. If the alternative hypothesis, gamma is less than zero, is deemed appropriate, then the spread will tend to mean-revert because the change in the spread at any given point in time is a negative function of the level of the spread. Higher spreads will tend to decline and lower spreads will tend to increase. Individual traders must use their own judgment to determine what degree of confidence is required. Keep in mind that the higher you set the confidence interval, the fewer opportunities you will find. On the other hand, if you set the confidence interval too low, you increase the chances of finding spreads that are not really cointegrated. At Bigger Capital, we like the cointegration confidence interval to be at least 90% using a few different time frames. Once you identify a spread that is likely to revert to the mean, another critical piece of information is how long it will take to revert. A spread that you expect to revert in three days is a much more attractive investment relative to a spread that you expect to revert in three years. We can calculate the half-life, which is the time it takes for the spread to revert to half its initial deviation from the mean, to determine the holding period for a mean-reverting spread. To calculate the half-life, we first need an estimate of the rate of mean reversion. The rate of mean reversion is the slope of the line Y = (X), a linear regression using the daily change in the spread (current spread previous spread) as the dependent variable and the difference between the current spread and the mean (current spread mean of spread) as the independent variable. Once we estimate the rate of mean reversion (), we can calculate the half-life using the equation provided in Ornstein-Uhlenbecks mean-reverting equation4:
Ideally, spread traders would prefer to look at spreads with a low half-life, but again, traders should use their judgment and their capital costs to determine what is
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acceptable. At Bigger Capital, we prefer spreads with half-lives of fewer than 50 trading days. Once you have identified a spread that is cointegrated with a reasonably short halflife, you need to identify an entry point where the spread has deviated from the mean value. The z-score is a measure of how far a spread is above or below the historical mean.5 We express the z-score in units of standard deviation. Expressing the deviation in terms of units of standard deviation allows traders to compare one spread to another. Once again, individual traders must decide how many standard deviations away from the mean makes a spread rich or cheap. At Bigger Capital, we look for spreads that are at least two standard deviations from the mean. There are no clear-cut answers to these questions of judgment. One trader may tolerate a lower confidence level for cointegration in exchange for a higher absolute value z-score. Another may want both a high confidence level for cointegration and a high absolute value z-score but care little about half-life. As far as the period you should use to calculate the above statistical measurements, we suggest looking at multiple periods for all the measurements. You may choose to give more weight to recent data (which we do), but don t ignore the longer-term measurements. If a pair looks cointegrated for two years but not five years, you may want to look for something else to trade. If something looks cheap using one year of data but expensive using four years of data, you may want to reconsider. The following example will illustrate our point. First, we define our spread as 10 * NFX 17 * BRY. On February 16, 2011, this spread closed at about -68. Using two years of data, this spread was cointegrated with a confidence level of 95%, had a 20-day half-life, and had a z-score of -2.1. It looked like a buy.
Standard Score, Wikipedia, last modified June 30, 2011, http://en.wikipedia.org/wiki/ Standard_score.
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Figure 6. 10 * NFX - 17 * BRY Spread Using Two Years of Data However, when you looked at five years worth of data, the picture changed. The spread was no longer showing strong cointegration and had a z-score of 0.7, indicating that if anything, the spread was rich. See Figure 7.
Figure 7. 10 * NFX - 17 * BRY Spread Using Five Years of Data Sure enough, by the end of the next day, the spread closed at about -117. The following day, it lost another 27 points. See Figure 8.
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Figure 8. 10 * NFX - 17 * BRY on February 18, 2011 The following is a framework for how to look at statistical spreads based on the concepts we discussed above. 1. Choose a time period or periods. We prefer looking at multiple time periods, but some traders may want to focus on only the short term or only the long term. There is no clear-cut right or wrong answer. 2. Is the spread cointegrated for the time periods you selected? This requires selecting a confidence interval. We recommend at least 90%. 3. How far from the mean do you wish to enter into a trade? Two standard deviations is a common entry point for many traders. While this is not a hardand-fast rule, we have tested entry points ranging from 1 to 3 standard deviations. What we find is that entering at 1 standard deviation means the spread is likely (mathematically) to continue outside of the range, because only 68% of observations are within the range -1 to +1 standard deviations from the mean. If we use 3 standard deviations as the entry point, the mathematical probability of the spread continuing outside the range is low. However, we find that often a move to 3 standard deviations is indicative of a change in the underlying cointegration model, where the pair will not be cointegrated going forward.
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4. Choose an exit point and, if desired, a stop-loss point. The targets you set will depend on your holding period preferences. Obviously, the farther away you set your targets, the longer your holding period will be. We should note that your target point does not necessarily have to be the mean. It could be halfway to the mean, or you could target a percentage return. If you are unsure as to how far you should set your stop-loss in relation to your profit target, we recommend that they be symmetrical to the entry level. Once you analyze a lot of spreads, you will find that it is difficult to think of spreads on your own that are cointegrated with a high confidence level. SpreadTraderPro delivers a daily list of highly cointegrated spreads for various time periods to assist with this process. Members can sort their daily scan by the criteria they find the most useful. See Figure 9.
Figure 9. Daily Scan in SpreadTraderPro Our daily scan contains two additional columns that we need to define. The zero crossing rate is the number of times the spread crossed the zero value for the defined period. A higher number implies a shorter holding period and a greater mathematical probability that the spread will not continue to trend. The sum of least squares is the squared distance over the selected period. The lower this number, the tighter the spread, and the better the chance that the price of leg one will not wander far from the price of leg two.
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The SpreadTraderPro daily scan is the most efficient tool available for statistical spread discovery. If you are not a member of SpreadTraderPro, you can still use our free tool, Spread Analyzer, to analyze spreads that you either think of on your own or that you find through Twitter or other sources. The input screen for Spread Analyzer often contains interesting, relevant spreads. See Figure 10.
For more information on statistical methods, please see the following video: Heat Map.
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Non-Statistical Methods
Many non-statistical spread-trading strategies are less rigorous in their criteria. Trading in-play stocks, momentum, earnings, and value are all examples of nonstatistical strategies. A good source of information for these types of spreads is our Ranked Spreads database for SpreadTraderPro members. The Ranked Spreads database can show you great spread pairs for a given stock that you are looking to trade. See Figure 11.
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2. Merger Arbitrage
When a merger is pending and the consideration is equity in the acquiring company, shares in the target company typically move in tandem with shares in the acquirer. The likelihood of completion of the merger will dictate the strength of the relationship. If a merger is considered highly likely to complete, then the spread (Target * Ratio Acquirer) will be trading close to zero. When a merger is considered less likely to complete, the spread will trade at a discount. In these cases, if the merger does complete, the spread trader who bought the spread (Target * Ratio Acquirer) will make a profit. If the deal falls through, the trader who shorted the spread will make money. For example, on April 11, 2011, Level 3 Communications, Inc. (LVLT) announced its intention to acquire Global Crossing (GLBC). Each shareholder in GLBC would get 16 shares of LVLT. If the merger were 100% certain to complete, the spread should trade at zero. As you can see from Figure 12, the spread trades below zero but increases toward zero as the probability of completion increases:
-2
-3 -4 -5 -6 -7
-8
-9 -10 4/1/2011 5/1/2011 6/1/2011 7/1/2011 8/1/2011 9/1/2011
Figure 12. Spread Increases with Probability of Completion If you had bought the spread in April at -2, you could sell it in September for close to zero. The risk is that the merger does not complete, in which case the spread would likely fall back below -8.
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We traded in and out of SPY IWM for a half percent or more gain intraday three times in the prior two weeks (read this post describing one of those trades). We sold the spread a fourth time late that Friday. See Figure 13.
c) Big expiration
When the U.S. market is facing a significant options and futures expiration around the third Friday of the month, the market experiences large swings as you approach the expiration of the derivatives market. Spread traders can take advantage of these setups. Triple witching is usually a fertile ground for opportunities.
d) Program trading
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Program trading can create sharp liquidity gaps, especially when the robots go mad. Fast traders can take advantage of these situations if they are good at recognizing what is going on in a timely manner.
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4. Trading the News a) Lvy flights: How to think about the news
Seth Godin wrote a fabulous blog post6 about a cool mathematical concept called the Lvy flight that shows up in nature.7 It also shows up in finance. For example, a journalist finds an interesting story to write about. Think about Merck and Vioxx.
Figure 14. An Example of Lvy Flight (Source: Wikipedia) That was big business news, and it stirred up emotions. Many people took a stance on both sides of the issues related to this event. Writing about Vioxx generated good readership and sold advertising. Thats the goal of the media, right? Eventually, readers got bored with the story and moved on. Our journalist had to find other news to generate traffic. The journalists path to different food sources followed a Lvy flight from one random walk to a cluster followed by the same process over and over again, as depicted in the image.
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Seth Godin, The Levy Flight, Seth Godin (blog), April 8, 2010, http://sethgodin.typepad.com/ seths_blog/2010/04/the-levy-flight.html. 7 Lvy Flight, Wikipedia. Wikipedia, last modified September 9, 2011, http://en.wikipedia.org/ wiki/Ornstein%E2%80%93Uhlenbeck_process.
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Or you can think about it this way: the path between each cluster is a stochastic directional vector, and the cluster is a manifestation of the cockroach theory. This theory states that if you find a roach in the cupboard, more than one roach is usually crawling in the same location. Using Godins example, once an animal finds food along its random walk, the animal will rummage in the same area because the likelihood of finding more food is elevated. You must think this concept is crazy, right? Here is another example of the same phenomenon. A few years ago, Twitter user @ashrust led me to the article Sharks Hunting Strategies More Like Physics Than Biology written by Brandon Keim, which considers Levy flight principles. Keim s article opens up another rich vein ripe for financial exploration: how sharks respond to the supply of food could have interesting implications for finance. Enough about animals: lets get back to humans. As traders, our food is stock prices discrepancies. For trading success, it is essential to understand what causes the price discrepancies in the marketplace. News and other phenomena, such as the mood of market participants, for example, influence stock prices on a daily basis. For this chapter, we will focus on news. Ryan Holiday wrote a great book about the media business titled Trust Me, Im Lying: Confessions of a Media Manipulator. Holiday describes how blogs control and distort the news. This book is a must-read as it will make you aware of what goes on in spin media, and it will help you understand the nature of the Levy flight. By understanding the dynamics going on during a Levy flight, a trader is in a better position to take advantage of the situation to his own advantage, especially when the media stirs up emotions to extreme levels. Heck, at times journalists and financial bloggers alike fabricate situations that do not exist just to generate traffic. They create food where none exists and distort market
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prices in the process. It is our role as traders to understand these dynamics and to implement trading strategies to take advantage of these situations. Here is a sample of questions you can ask yourself to understand the impact of the news on the securities that you have identified as being in play:
1. 2. 3. 4. 5. 6. 7. 8.
What is the relationship between the news, the volatility, and spread values? How long will it take the media to migrate from this story to the next? When do you expect the pressure to abate? When the pressure does abate, do you think the spread will revert to the mean? Can you identify a similar situation in the past that you can use as a proxy to model how this situation will behave? What is the reaction of traders and investors? If they amplify the news, will the situation stabilize once they get bored and move on to another story? Can you find other candidates that could be influenced by this situation that have sold off and are punished unduly (Cockroach theory)? Which type of trade do you implement to exploit this situation?
When the next Vioxx crisis erupts, I will remember that the media will eventually walk away and let it go. The news will subside, as it always does. As Benjamin Graham once said, This too shall pass. Since I wrote the original post, weve used this mental model to sell volatility on Goldman Sachs when the fraud scandal erupted in April 2010. You can read more about it here: Levy flight, Truffle Diggers, and Goldman Sachs. The trade was highly profitable, and we unwound this trade in early July 2010 after the truffle diggers got bored and moved on to another story. The Gulf of Mexico became a much more powerful story to coverthen the North African crisis, the Japan crisis, and so forth.
reporting periods, TPX announced earnings prior to SCSS. In each case, a solid earnings report from TPX was followed by a solid earnings report from SCSS. We took TPXs announcement as a strong indicator that SCSS would also report robust results in late April. The 5 * SCSS 1 * TPX spread had been trading around $10 since the prior quarters results. It closed at $10.76 on April 7, so when it dipped below $8 in after-hours trading, we bought it. We bought some more on the morning of April 8, also slightly below $8. As it turned out, we could have waited a little longer because the spread at one point dipped below $5 and closed Friday at about $5.60. Nevertheless, based on the cockroach theory, we were confident it would return to the $10+ level. On Thursday, April 21, we provided the following update to our SCSS TPX trades on April 7 and April 8. On both dates, we bought five SCSS and sold one TPX on the back of a rally in TPX after the firm said it expected strong first-quarter results. In the prior two reporting periods, SCSSs results mimicked TPXs results, and we were betting the same would happen this time. Sure enough, SCSS significantly beat expectations when it reported earnings. The stock went up 28%. We unwound the spread the day after the report for an approximate 13% return. This is how the cockroach theory can help you identify juicy situations. A good way to find candidates for the cockroach theory is to look for big daily moves in stocks. When you see one stock move higher (lower) due to earnings, think about other similar companies that might also report good (bad) earnings. If one stock is the target of an acquisition, look for competitors who might also be potential targets. For a hedge, use the company with the original price move (in our example above, TPX). You can also use a sector ETF or the broad market.
During that episode, you could also have traded the relationship between gold ETF and the miners. As Warren Buffett says, Be fearful when others are greedy and greedy when others are fearful.
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Go where the crisis is, young man! Typically, a crisis is easy to find. It is top news on every TV channel and news site on the Internet. The hardest part is buying in this case. Buffetts quote should inspire you to buy when others are selling in crises. The buy side of the spread is always the target of the crisis, whether it is Japan (EWJ), nuclear stocks, Steve Jobss resignation as CEO of Apple, or even U.S. indices. The hedge side of the spread can be a sector ETF or another broad market index.
Some events are known in advance (e.g., earnings announcements). You can get a calendar of upcoming earnings announcements from CNBC or from Yahoo! Finance. The site Finviz allows you to screen for stocks reporting earnings in any number of
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time frames, including today, after the close, and tomorrow before the open. You can research the stocks in advance so you know what earnings number is expected. If there is a surprise and a big move when the event occurs, you can trade the spread using a competitor, sector ETF, or the broad market as a hedge.
ii.
Here is an example of how you can trade the positive news about a company. We traded this spread at the end of June 2012. With the introduction of its Nexus tablets and its glasses, Google (GOOG) will have an abundance of fresh news in the next few months, which will create trading opportunities. This situation is appealing to us because the stock is statistically cheap against the Technology Select SPDR (XLK), as you can see on the Spread Analyzer image displayed below. GOOG is also cheap against Intel (INTC) and the triple Qs (QQQ), but we like the $spread better against the XLK given the volatility of the spread. This vehicle will move quite a bit on fresh news and traders can take advantage of this by leaning on GOOGs cheapness. You can look at the $spread within the analyzer here for more clarity. You can play around with the time frame or run GOOG against any others stocks of your choosing. At the time of this writing (9/4/2012), we are long GOOG against INTC, QQQ, and XLK.
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Figure 16. COH After Earnings Release in August 2012 For example, in early August 2012, Coach (COH) reported earnings, and the stock gapped down more than 20% on the news. When a situation like this arises, the first thing I look for is potential pairs using our Scan All feature.
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I decided to investigate the XLY COH spread further, since I had already rated this one in the past and was familiar with it. I had been monitoring it for quite some time. For my style of trading, I did not want to enter the trade right away while the news was still fresh. Often, big gaps down like these will be followed by more weakness. I wanted to buy COH and sell XLY beta neutral on some strength.
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Figure 18. XLY COH Spread The spread spiked to 90.09 on that day. I set an outbound alert at 75 thinking that once the spread reached this level, it would probably continue lower on momentum.
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Figure 19. Setting Alert on XLY COH On August 3, the system alerted me that the spread had reached the set level, so I sold the spread at 74.81. On August 8, I bought back the spread at 46.07 for a profit of almost $30 per spread. It was a great situation.
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Here is a video about how Jennifer Galperin traded COH earnings on the same day. She chose a different spread, and she talks about this in her video, which you can find here: COH Earnings Daytrade.
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sense for that type of viewpoint). Use our Scan All feature to find spreads that contain your in-play stock.
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6. Dual-Class Shares
Companies with dual-class shares can present an opportunity for spread traders. See Dual-Class Share: A First-Class Strategy for information on this strategy.8
Paul H. Schultz and Sophia Shive, Mispricing of Dual-Class Shares: Profit Opportunities, Arbitrage, and Trading, Turnkey Analyst (blog), March 26, 2011, http://turnkeyanalyst.com/2011/03/dualclass-shares-a-first-class-strategy/.
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7. Patterns
By taking the market out of the equation when looking at the relative pricing of two securities, you will be in a better position to identify patterns at different time scales and trade around them. Look for patterns related to volume, percentage moves, or anything else you can think of. Start your search for profitable patterns by following your favorite spreads (just a few to keep the task manageable) on a daily basis and pay attention to what is going with them at different time scales, especially intraday. To start, you may want to look for spreads between ETFs that track important economic indicators, such as SPDR S&P 500 ETF Trust (SPY), iShares Barclays 20+ Year Treasury Bond (TLT), iShares Russell 2000 Index (IWM), SPDR Dow Jones Industrial Average (DIA), SPDR Gold Trust (GLD), and others.
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Execution: Choosing Entry Price, Size, and Time Execution: Choosing Entry Price, Size, and Time, \\try Price, , and Time
Choosing entry price, size, and time depends on a number of factors. Some of these factors are going to be highly specific to each individual trader (such as total capital and risk appetite). Other factors will apply generally, such as liquidity and volatility of the underlying securities. For the most part, though, strategy type often dictates price and time. If your strategy is based on statistical methods, your entry price and time will for the most part be determined by how far from the mean the spread has diverged. If it has diverged past a pre-specified amount, you put the trade on. You can adjust the size based on how far something has diverged from the mean and how strong the cointegration is. Also, it is preferable to do many small trades when using statistical methods because you may lose money on some spreads, but you will make more money on your winners. For trades where there is an event (earnings or other expected news), your entry time and, to some extent, price are determined by the event. For example, in the SCSS TPX spread, the entry event was TPX earnings, and the exit event was SCSS earnings. Entry and exit points can also be driven by gap moves in the spread. For example, one morning several months ago, shortly after the open, the spread 4 * GLD 9 * GDX was trading at +1.5. By late afternoon, the spread was trading about -3.5. We had a bid in at -5 for the spread but decided to move the bid up. The $5 downward move was too big to ignore. Trading volume for both ETFs, while large compared to most stocks, was only about 70% of normal for GDX and 50% of normal for GLD. Thats probably enough to cause this type of move. Whatever the reason, it was really just noise. And it was an opportunity to exploit. We got long again at -3.3, and by the end of the day, the spread moved up to -0.37. Monday morning, 15 minutes after the open, we unwound the GLD GDX we had bought late Thursday for an $8.5 gain per spread.
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Extensive and cutting-edge application programming interface (API) technologies; for traders with little or no programming experience, we recommend going with a broker that offers a simple DDE for Excel platform, as Excel offers a familiar and user-friendly interface Breadth of products in both type (stocks, bonds, futures, commodities, currencies, options, etc.) and geography (global) Powerful algorithms you can use to make money right out of the gate Continuing education via webinars Strong credit and well capitalized Reliable and fast mobile platform Portfolio margin capability; margin based on risk, not regulation T Once you have selected your broker, you will probably want to keep track of the great spreads youve found. You may even want to be alerted when these spreads get to levels where you want to enter or exit a position. The best software we have found for this type of tracking is SpreadTraderPro. Our augmented Spread Analyzer features allow you to keep track of past queries, rank spreads based on certain criteria, and set alerts for when spreads reach desired levels. Plus, you can enter your trades and a separate tab will calculate your P&L by spread position each day, month, and year.
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Risk Management
Risk Management
The key spread-trading risks to pay attention to are the following:
Unlimited risk on short side Correlation risk Cointegration risk Concentration risk M&A risk Short squeeze risk Opportunity cost risk Specific risk Market risk Political risk Execution risk (if legging into spread) The unexpected Adverse momentum
The spread-trading business is statistical, which means high volume and small size. There are diseconomies of scale in financial markets. Diseconomies of scale means as you increase the size of your position, the expected P&L declines. Spread traders are exposed to the short leg, and that is one of the reasons spread traders should keep their positions small relative to the size of the portfolio. Start small! Example: The Gold Spread Moves Sharply Against Us (5-15-2011) The spread that occupied most of our attention this week was $GLD-$GDX, and we didnt even trade it this week. We have been short $GLD-$GDX since late April, and the spread recently moved sharply against us. The spread is
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currently trading at its highest level since late 2008. Of course, its always a good idea to re-evaluate a position that has made such a large move. Weve decided to leave it on for now because we dont believe there has been any fundamental change in market conditions to justify the current level. We feel the move is attributable to the recent sell off in silver (and other commodities). We think this sell off spooked some holders of $GDX even though gold itself has held up rather well compared to other commodities. Also, our position is relatively small compared to the size of our portfolio. We try not to have many positions that are so big that we can t take a little pain once in a while. Table 1 shows some of the risk you have with the corresponding pairs structure:
Stock B Stock B
Same Different
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Despite the increase in the value of the spread, $SPY rallied last week. We took this opportunity to initiate a short position. Notice the sharp spike up in the spread on September 2, followed by a sharp drop in $SPY on September 3. On September 22, the spread had a strong move downward, indicating that someone might be willing to take more risk out there (could be an aberration). On September 22, we traded from a long bias in the afternoon and made good money on that basis. Could the spike indicate a rally ahead? Maybe or maybe not, but we are looking to short the market aggressively if the spread spikes back up. If the spread continues declining and the spread holds its own, we will be active from a long perspective (small size) with a short-term horizon (a few hours).
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Figure 25. 1-Month SPY Chart Does this sound like a good game plan?
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Creating Signals
In the prior chapter, we explored using spreads to form a directional opinion. If you find a spread that has predictive values, you can use the spread or a weighted basket of spreads to create your own proprietary buy or sell signal. You can create signals by using a few spreads that you think have predictive value and assign a weight to each spreads daily percentage sign to create your own predictive index. Over the last few years, we have discovered a number of spreads with predictive value. We have called these spreads predictive because they are cyclical in nature. They can go to an extreme level, but, over time, they will revert to the mean.
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120 100 80 60 40 20
2/28/2011
2/29/2012
Figure 26. Spread 1 Versus S&P 500 As Figure 26 shows, when the spread increases in value, the S&P 500 declines; conversely, when the spread declines, the S&P 500 rallies.
Volatility Spread 2
We use this spread to forecast the incoming volatility in the marketplace. As Figure 27 shows, when our volatility spread increases, the range of the volatility in the market dramatically increases.
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800
600 400 200 0 8/31/2010 2/28/2011 S&P500 8/31/2011 2/29/2012
-25
-30 -35 8/31/2012
Figure 27. Relationship Between Volatility Spread and Range of Volatility in the Market Both short-term VIX tracker VXX and medium-term VIX suffer from contango. We recommend that you visit the topic about contango and backwardation in a later section.
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3 2 1 0 -1
-2
-3 8/27/2012
2/27/2011 S&P500
8/27/2011
2/27/2012
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Gold Spread
This is one of the most interesting spreads we have come across at Bachelier LLC. It measures the flow of capital from equities to gold. Historically speaking, gold is considered to be the most pure, safe, and secure form of storing wealth, as it protects capital against inflation and market volatility. Over the last two years, gold has continued to underperform SPY. During every dip in the market in 2011 and 2010, people have bought gold. Therefore, its no surprise that the S&P 500 reached a new 52-week high this year not seen since the violent crash in 2008. Despite the fact that gold lags the equities market, one can look at the daily changes in the spread to measure the short-term market sentiment. See Figure 30.
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Scoring: Our scoring is 1 for risk appetite, 0 for flat when the spread is unchanged, and -1 for risk aversion. Now the interesting bit is that we have four spreads in the spreadsheet. Similar to Spread 1, each spread will have a score of 1, 0, or -1 depending on the market
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sentiment. We have assigned each spread a weight as follows: Spread 1, 0.5; Spread 2, 0.2; Spread 3, 0.2; and Spread 4, 0.1. Add these together, and we get 1.0. We then multiplied the weight to the score of every spread. The result is the overall market sentiment. If you have created such a signal and it contradicts another predictive spread that you are following, there could be an opportunity to trade this spread, expecting that it will get back in line with the signal. We will rank many ETF spreads that have some degree of predictive power. SpreadTraderPro members who rank spreads have access to this treasure trove of information.
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Dividends
Dont forget to factor in dividends when calculating the price of a spread on the day that one of the stocks trades ex-dividend. This is best illustrated with an example. Suppose you are long one share of Stock A at $55 and short one share of Stock B at $50. In other words, you paid $5 for the spread. Suppose Stock B pays a $1 dividend, and on the ex-date, the price of Stock B drops to $49. Dont rush to unwind the spread because you think you just made $1. Dont forget that you owe a $1 dividend on the stock you borrowed. Keep this in mind for statistical analysis as well. Some data sources will adjust for dividends and stock splits, and others leave that up to you. It is important to know what your data source does in these cases.
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Carry Costs
In calculating the profit and loss of a spread trade, dont forget to take into account carry costs. You will pay interest on your long position and collect interest on your short position. The rate you pay on your long position will be higher than the rate you receive on your short position. For short-term positions, the carry cost wont have a significant impact, but if you hold long-term positions, you need to take carry costs into account. This may also affect your choice of spreads (targeting a shorter half-life when carry costs are high) or your entry/exit decisions.
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Contango/Backwardation
Contango refers to the situation in which the price of a longer-dated futures contract
is more expensive than the price of a shorter-dated futures contract. This is usually the case for nonperishable commodities. For example, the United States Oil Fund (USO) tracks oil prices by buying oil futures. Because the fund does not wish to take delivery of the oil near expiry, it rolls the futures contract forward to the next month, usually paying up in the process due to contango. This can adversely affect the price of an ETF like USO. Below is an example of how contango adversely affected the price of the 10 * USO 3 * Market Vectors Oil Services ETF (OIH) spread in late 2010 and early 2011. Notice the downward drift in the spread over time due to contango. This occurred during a period when oil prices rose sharply.
0.00
-10.00
-20.00 -30.00 -40.00 -50.00 -60.00 -70.00 USO-OIH
-80.00
-90.00 -100.00
Figure 31. Contango in 10 * USO 3 * OIH, Late 2010 and Early 2011
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If the futures price is lower than the spot price, the situation is called backwardation. Typically, backwardation indicates a current shortage, and contango indicates a normal or even a surplus situation. Volatility (VXX) and Natural Gas (UNG) are good examples of spreads trading in contango at the moment.
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Trading Options
In the chapter titled Choosing a Spread, we discussed cointegration as a metaphorical spring mean-reversion model. Options traders can incorporate this concept of a spring in their decision making to find spread patterns to exploit using options. The linkage between two securities can tip the advantage in the favor of astute traders who learn how to read what a spread tells them. Options strategies are numerous, and it is not our intention to go deeply into options trading. Our goal is to make you aware of the possibilities that spreads represent for options traders. There is no better way to do this than to give you one example of how we implemented an options trade using a cointegrated spread with positive momentum. On August 29, 2012, Bob Love (@boblove) and I posted the following tweets:
I replied that at the five-year time frame, the spread was cointegrated. You can view the spread in our analyzer at this link: http://goo.gl/5MqQq or in Figure 32.
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Figure 32. Cointegration of VLO HES Spread Looking at this spread, I noticed right away that VLO had strong momentum and that HES had plateaued at a short time scale (1 month). Given the strong cointegration at the five-year time scale, there was a good chance that HES could follow VLO on the
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upswing. I decided to sell a short-term put on HES. As I mentioned in this tweet, I wanted to use this trade as an example for this manual.
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Figure 34. Short-Term Put Option on HES A week after I initiated this trade, I was able to unwind it for a $0.34 profit per option.
The reason I made money on this trade might have nothing to do with the structure of this spread. There are unlimited factors as to what justifies options prices. However, I do believe that if a trade pattern is statistically advantaged, the chance of a positive outcome is greatly enhanced.
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Creating a Playbook
Spread trading is a broad category encompassing everything that involves buying one security and selling another as a hedge. Within spread trading, there are many different strategies. You may stick to one strategy, or you may wind up trading a few different strategies. You might, within equity spread trading, allocate some of your capital to these strategies I have listed or any number of other strategies. Think of each strategy as a play in a football playbook. Sometimes you do a passing play and other times a running play; you need to mix it up to win the game. In certain market conditions, you use one strategy more and another strategy in other conditions, but it is helpful to have a mix of good strategies available to you. But before you can have multiple strategies, you need to develop one good strategy. There are many ways to develop a winning strategy. First, you start with an idea. Any one of the methods discussed in this booklet can be a starting point for your trading strategy. I keep a document where I start with my idea and add on over time as I refine my strategy. In my document, I lay out the universe of stocks (or spreads) that I will consider: for example, what countries I include, market cap limitations, liquidity limitations, sectors, and anything else I think is important. You may even specify a list of specific stocks or spreads you want to trade, if your strategy calls for that. I then write how I narrow down that universe of spreads to the ones I plan to trade on any given day. Those instructions will depend on what type of strategy you are developing. For example, this playbook is for statistical spreads, so I look for statistical arbitrage candidates trading around two standard deviations from the mean. Depending on your strategy, you might look at all stocks reporting earnings and find spread pairs to trade with the in-play names. You might look at a list of 30 stocks or spreads that you know well and look for trading opportunities there. I lay out my notional size per trade (which should be somewhat consistent or at least weighted by some guidelines). I then describe each trades entry strategy, exit strategy, and stop-loss strategy. Each strategy will typically start with an experiment, and I make a note of the parameters I want to experiment with. For example, a play might say that if a statistical arbitrage
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spread gets to -2 z-scores, then I buy it, targeting an exit at -1 z-scores. I might experiment with buying spreads at 1.5 z-scores or waiting until they get to 2.5 zscores. You can experiment by trading the strategy to see how it performs, or you can design a back-testing program to tell you how your strategy would have performed over certain periods. Back-testing programs depend on rigorous entry signals, so depending on your strategy, this may or may not be possible. Once you have a basic idea with some parameters to experiment with, you are ready to start with a few small trades. Start small at first until you are comfortable because you want to save capital for additional opportunities that will likely come your way. Test your first trading strategy with a few trades, and build a small portfolio of trades. Remember to diversify your entry points. To do this, think of your time frame for investment. Do you plan to hold each position a few days, a few weeks, or longer? Spread out your entry points across your holding period. If you plan to hold each trade for a month and you want 20 positions, then you should do approximately one new trade per day. Dont put on 10 trades on the first day, because you will soon run out of capital. Depending on your time frame, you may be able to build a small portfolio within a few days, or you may need several weeks. As you put on new trades and close old ones, experiment with the entry and exit strategies until you find what makes money consistently. Think of your playbook as a living document, where you update as you adapt strategies or as you discover what works and what doesnt. You may adapt to changing market conditions and come back to old strategies in the next market cycle. You can also add other factors: for example, what to do if a stock has just reported earnings or is about to report or whether to include or exclude M&A stocks. When I first started my spread-trading framework, it was a few paragraphs. Over time, I have grown it to many pages by adding successful trades, taking note of unsuccessful strategies, and tweaking my plays. When I have a very successful (or unsuccessful) trade, I add a chart of the trade and note my entry and exit points. If you are able to describe your strategy numerically, you may even be able to design an algorithmic trading program to trade it using an API. Or, you might keep the actual trading decisions up to you. For more information about building a spread-trading playbook, please watch our webinar here.
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Conclusion Conclusion
We will conclude with a list of some things weve learned, some of which apply to all spread strategies, and some of which are strategy specific. Be able to clearly identify and articulate your rationale for the trade, whether its statistical, fundamental, a liquidity gap, etc. Always choose an entry and exit point based on price and time. Know and understand the various risks involved in your trading strategy in general and in each trade you do. Continue to experiment and refine your strategy all the time. Maybe the market will change, in which case you will need to evolve to succeed. Or maybe your strategy is good but could be better with a slight tweak in parameters. To do this: o Keep track of the P&L of each trade and your entire portfolios. What types of trades are most and least profitable? Under what market conditions are you most profitable? Can you identify any patterns about which types of trades are more profitable in different market conditions? o Track the P&L of each spread after you unwind it. Perhaps you are unwinding too soon or not soon enough. o Track the P&L of each leg of the spread. Where are you making moneyon the long side or the short side? Keep track of general observations. Here are some that we have found. Think about whether you agree or disagree with these, and try to come up with observations of your own. o In our statistical book, we have found that it is not necessary to choose two stocks from the same industry. o For our statistical book, profits increased with increased volatility in the market. In times of low volatility, profits tend to be lower. o We have found that it is best to set your target profit and stop-loss so that they are symmetrical.
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The sum of least squares is the squared distance over the selected period. The lower this number, the tighter the spread is and the better the chance that the price of leg one will not wander far from the price of leg two.
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Evan Gatev, William N. Goetzmann, and K. Geert Rouwenhorst, Pairs Trading: Performance of a Relative-Value Arbitrage Rule, available at http://www.google.com/url?sa=t&rct=j&q=&esrc=s& frm=1&source=web&cd=3&ved=0CCwQFjAC&url=http%3A%2F%2Fciteseerx.ist.psu.edu%2Fviewdoc %2Fdownload%3Fdoi%3D10.1.1.191.961%26rep%3Drep1%26type%3Dpdf&ei=YwzhTqDIJOLx0gG7h uXKBw&usg=AFQjCNFSNekAQh7gOiwJ1jeSz55nYDY-5Q&sig2=Rt99vufJpxWr2TVJgT72ug.
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What do you think? Do you think statistical spreads need to be pairs of similar companies, or can you make money trading statistical spreads with companies in different industries? Jennifer Galperin Comment on this text: Several months ago, I would have agreed with Jennifer, but I have since changed my mind. Ultimately, you are trading future cash flows, so it doesnt matter which industry generates those cash flows. It is almost impossible to gauge how the various factors you mention affect short-term price fluctuations, even within the same industry, so you let the stats tell you the likelihood of those fluctuations being noise or real. Norm Winer
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Figure 39. Spread Analysis SPY IWM If you want to become a professional trader, there is a lot to learn. When you are first starting out, SPY IWM is a great product because it is liquid, is easy to understand, can be traded on a short (but not instant) time frame, and provides lots of opportunities to make money. It will help you learn some of the subtle yet important aspects of trading, such as:
Setting probabilistic and symmetrical stop-losses Understanding emotion and its impact on the market Interpreting liquidity gaps and spikes Finding pricing lags in one security versus another Recognizing changes in the market environment, and how to adapt your strategy Comprehending intraday time windows
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Darwin the Trader Charles Darwin is widely known as the man behind the theory of evolution. He theorized that through evolution, a species could adapt to different environmental conditions. Those individuals who did not adapt would not survive to pass along their genes. A friend said to me the other day, It is the markets fault I lost money trading last month. I could have agreed with my friends opinion since I have spent the last two years building my quantitative strategy, and I have had plenty of setbacks along the way. But now, in the current low-volatility environment, I am making money trading my strategy at a short time scale, choosing my entry points wisely, and capitalizing on many small gains. At various points in my journey so far, I have had to cut limbs to survive. I had to admit I did not know much about quant strategies when I started. I made mistakes, and I took steps back to think. I iterated, retested, and moved forward. What has worked for me is to adapt to different market conditions all the time. Like a football team, I started by building a book of plays that will work at different times, against different opponents, and in different market environments. I learned that what worked last week may not work this week or next week. I need to understand my opponent by recognizing trends, inflection points, and themes in the market, all of which can change on a dime. I use my growing playbook to exploit this situation. If you build a good playbook, you will have the trades set to make money in any market conditions by adapting and evolving. A playbook is the tool I have built to adapt. So how do we adapt? For quantitative traders, this can be one of the hardest things to do. Computers dont learn and adapt; they just crunch numbers. Humans need to think carefully about the inputs. Maybe that means we ask the computer to look at performance of the strategy in bull and in bear markets, in low- and high-volatility environments, or in times when oil prices are low and highwhatever we think might affect our strategy. Maybe we find that when certain market conditions are in effect,
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we need to tweak our strategy (or radically change it). Then, experiment with the change. Try one or two small trades to see how they perform. But dont get too comfortable, because the next change in the market is just around the corner.
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Spread Trading and Takeovers One morning I came in short Taleo (TLEO) at about $39.50 as part of a spread I initiated the previous day. Oracle announced that morning that it was buying TLEO for $46 per share. Bad news! How do you prevent something like this from happening? The short answer is that you cant. But there are a couple of things you should be doing to lessen the pain and decrease the frequency of such events. First, you should create a diversified portfolio that can withstand such a move. TLEO represented less than 2% of the portfolio. Second, you should be certain that your process is not getting you into situations like this on a regular basis. If it is, you might want to rethink your strategy. In our case, it hasnt. Sometimes weve been on the winning side of these events. If your process is sound and your portfolio is diverse, events like this will occasionally occur, but they shouldnt prevent you from being profitable over the long run.
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Taxes
Readers are advised not to act upon this information without seeking the service of a professional tax and/or financial planner. Spread trading can create complicated tax issues, and spread traders should review their spread-trading tax implications with their professional tax advisers at least once a year. At BiggerCapital we trade spreads in a Section 475 election trading vehicle. You can learn more about this right here. Please discuss this and any other tax issue with a professional who understands your specific situation
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