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Pairs trading


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Pairs trading

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  #1 (permalink)
crazymatrix
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I've been trading for ~6 months, so I'm still fairly new. I have a knack for getting direction wrong, so I'm looking at some directionally neutral trades. I understand the concept of pairs trades: buy one, sell the other short and then profit from the change in the spread between them, but I'm not sure about the details.

How do I know when to jump in? I watched some videos about finding the mean between them and then taking a position when one moves away from that and waiting till it reverts to the mean.

When I know, how do I know which side to long and which side to short?

For example, I'm planning to try this out with the new micro futures, Micro E-mini S&P 500 (MES) and Micro E-mini Dow (MYM).

MES is $5 x S&P 500 Index
MYM is $0.50 x DJIA Index

Today the difference would be:
($5 * 2,870.72) - ($0.50 * 25,828.36) = $1439.42
I suppose I would wait till this decreased towards zero.

But I could also go the other way and wait for it to come up to zero, right?

($0.50 * 25,828.36) - ($5 * 2,870.72) = -$1439.42
How do I choose?

Any advice related to pairs trades would be appreciated.

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  #3 (permalink)
 kevinkdog   is a Vendor
 
 
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crazymatrix View Post
I've been trading for ~6 months, so I'm still fairly new. I have a knack for getting direction wrong, so I'm looking at some directionally neutral trades. I understand the concept of pairs trades: buy one, sell the other short and then profit from the change in the spread between them, but I'm not sure about the details.

How do I know when to jump in? I watched some videos about finding the mean between them and then taking a position when one moves away from that and waiting till it reverts to the mean.

When I know, how do I know which side to long and which side to short?

For example, I'm planning to try this out with the new micro futures, Micro E-mini S&P 500 (MES) and Micro E-mini Dow (MYM).

MES is $5 x S&P 500 Index
MYM is $0.50 x DJIA Index

Today the difference would be:
($5 * 2,870.72) - ($0.50 * 25,828.36) = $1439.42
I suppose I would wait till this decreased towards zero.

But I could also go the other way and wait for it to come up to zero, right?

($0.50 * 25,828.36) - ($5 * 2,870.72) = -$1439.42
How do I choose?

Any advice related to pairs trades would be appreciated.

If you are playing mean reversion, hoping the difference converges back to historic levels, you sell short the overvalued one, and buy the undervalued.

But, what makes you think one or the other is over or under valued?

For example, you will be waiting FOREVER for that difference to get even remotely close to 0. For the minis, it got as low as 3000 back in 2009 (for continuous contracts). It has never hit zero, at least with continuous contracts.

And again, WHY should it hit zero?


I don't think you'll find any kind of over/under value type situation in these indices.

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  #4 (permalink)
 centaurer 
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Lets not forget too that the DOW is a subset of the S&P 500. If you short the DOW and long the S&P you are betting on the DOW stocks in the S&P being over valued relative to all the other stocks in the S&P.

You can't just want to put on a strategy for no reason.

Statistical arbitrage is not something I completely get and surely not something someone can just explain what to do in a post.

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 kevinkdog   is a Vendor
 
 
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centaurer View Post
Lets not forget too that the DOW is a subset of the S&P 500. If you short the DOW and long the S&P you are betting on the DOW stocks in the S&P being over valued relative to all the other stocks in the S&P.

You can't just want to put on a strategy for no reason.

Statistical arbitrage is not something I completely get and surely not something someone can just explain what to do in a post.

Not to mention one is market value weighted, and the other is price weighted.

There are valid pairs to trade, but YM vs ES is likely not exploitable by retail folk.

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  #6 (permalink)
 SMCJB 
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I agree with @kevinkdog and @centaurer 's points but answering your question from a theory perspective, I think your looking at it wrong.

In your example you need to determine a relationship between ES & YM, and then when they seem to have violated that relationship you could put a trade on that would be profitable if the relationship returns or holds. For example you could calculate a linear regression between them and decide to enter a trade when the current prices are say one standard error away from the projected price. Once you decide to enter a trade you would need to do it on a risk weighted basis. The easiest (but incorrect) way to risk weight would be to use contract dollar values but you would not regress the dollar weighted contract values!

I believe if you hunt around out there, you may even find a webinar where @kevinkdog demonstrates something similar with a Gold-Silver spread/pairs trade.

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  #7 (permalink)
 SMCJB 
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I should also say, while I think you are currently thinking about this wrongly, the fact that you are thinking about this at all with as little experience you have, is impressive. Many traders, struggle to master any trading, never mind grasp pairs or spread trading.

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  #8 (permalink)
 kevinkdog   is a Vendor
 
 
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SMCJB View Post
I should also say, while I think you are currently thinking about this wrongly, the fact that you are thinking about this at all with as little experience you have, is impressive. Many traders, struggle to master any trading, never mind grasp pairs or spread trading.

Excellent observation!

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  #9 (permalink)
crazymatrix
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SMJCB
Once you decide to enter a trade you would need to do it on a risk weighted basis. The easiest (but incorrect) way to risk weight would be to use contract dollar values but you would not regress the dollar weighted contract values!

I understood everything up until that part and got lost here. Could you give an example or something I could go and read up on further?


kevinkdog
For example, you will be waiting FOREVER for that difference to get even remotely close to 0. For the minis, it got as low as 3000 back in 2009 (for continuous contracts). It has never hit zero, at least with continuous contracts.

And again, WHY should it hit zero?

I was just pointing out that it should start tending towards zero. I would close the trade as soon as it were profitable (so probably long before zero).


centaurer
You can't just want to put on a strategy for no reason.

It's not for no reason. I'm deliberately looking for strategies that are directionally neutral and looking for contracts and situations where I can apply them. I've also been reading up on options, which seem to offer more flexibility in that regard, but options theory looks more complicated.



Yes, I have learned about trading various types of spreads with other contracts, e.g. gold/silver, crude oil/natural gas, calendar spreads, etc. The main problem is I only have a $4000 account, so I can't really afford those classic spreads on the major contracts. I mostly trade E-micro gold (MGC), but I keep getting the direction wrong and after a few months I'm mostly break-even. There's no E-micro silver to play off that, so I'm basically looking for two smaller-sized contracts that will work well together.

I took this idea from Investopedia -- unfortunately I can't post links yet -- but search for their article "Pairs Trading: Correlation". They have a nice chart there with S&P 500 and Dow as an example and seem to think it's a reasonable pair. Obviously you guys think otherwise.

Of course I could trade calendar spreads on MES, but again, as far as I understand, I would have to choose a direction and make either a bullish or bearish trade.

One other idea I heard of for smaller accounts was buying a couple of micro contracts, (e.g. MES) then selling an options credit spread on the corresponding major contract (ES) to hedge it and finance it. Have any of you tried something like that?



By the way, I realize this is kind of a general thread and not directly related to E-minis. Feel free to move it to a more appropriate subforum.

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  #10 (permalink)
 SMCJB 
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crazymatrix View Post
I understood everything up until that part and got lost here. Could you give an example or something I could go and read up on further?

Do you understand what a Beta of a Stock is? In a common equity pairs trade you would want to structure the trade so you are Beta Flat or Neutral this is very different than dollar flat or share flat.

crazymatrix View Post
Yes, I have learned about trading various types of spreads with other contracts, e.g. gold/silver, crude oil/natural gas, calendar spreads, etc. The main problem is I only have a $4000 account, so I can't really afford those classic spreads on the major contracts. I mostly trade E-micro gold (MGC), but I keep getting the direction wrong and after a few months I'm mostly break-even. There's no E-micro silver to play off that, so I'm basically looking for two smaller-sized contracts that will work well together.

I see your point. $4000 really isn't much for this type of trading! Even with the smaller contracts it will be difficult for you to correctly size trade, and if you don't correctly size trades you will have directional risk. The problem with equity index spreads or pair trades is exactly what @centaurer said. The most obvious example is that Apple represents 3.75% of the S&P500 and 5.27% of the Dow.


crazymatrix View Post
Of course I could trade calendar spreads on MES

NO. Equity Calendar spreads are purely a function of Cost of Carry versus Dividends. They are arbitragable by the big players. They don't move around like many commodity calendar spreads.

crazymatrix View Post
One other idea I heard of for smaller accounts was buying a couple of micro contracts, (e.g. MES) then selling an options credit spread on the corresponding major contract (ES) to hedge it and finance it. Have any of you tried something like that?

Now you seem to be reaching to just find something you can trade! It is true though that the new micro's would allow you to delta hedge single eMini size option contracts.

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  #11 (permalink)
crazymatrix
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SMCJB
NO. Equity Calendar spreads are purely a function of Cost of Carry versus Dividends. They are arbitragable by the big players. They don't move around like many commodity calendar spreads.

Thank you for pointing that out. I'm not sure of the finer details yet.



SMCJB
Now you seem to be reaching to just find something you can trade!

To some extent, yes -- I can't do much with $4000 -- and I'm just looking around at various possibilities. I might just keep trading MGC directionally for now, keep studying and saving, then come back next year with more money and more knowledge.


Anyway, thanks for the quick replies.

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  #12 (permalink)
 LittleFinger 
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crazymatrix View Post
For example, I'm planning to try this out with the new micro futures, Micro E-mini S&P 500 (MES) and Micro E-mini Dow (MYM).

I'd consider calendar spreads or metals vs the dollar

edit: oops you already mentioned calendar spreads.

if you didn't mention currencies maybe something like gbp/eur would be a good choice

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  #13 (permalink)
crazymatrix
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LittleFinger View Post
I'd consider calendar spreads or metals vs the dollar

Ah, maybe MGC against M6E or M6B might be a better fit for me?

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  #14 (permalink)
 LittleFinger 
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Yeah the micros could work for you. NZD/AUD is another one

JPY/ES

edit:
i mean nzd/usd vs aud/usd and jpy/usd vs es

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  #15 (permalink)
 centaurer 
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crazymatrix View Post

It's not for no reason. I'm deliberately looking for strategies that are directionally neutral and looking for contracts and situations where I can apply them. .

I guess I mean a strategic reason as opposed to a predetermined desire.

My limited understanding of pairs trading is you should have some kind of scan to find pairs that are cointegrated. If the pair is not cointegrated then you can't take a proper average to judge the divergence. Of course there is a risk if you look at enough data you will find basically spurious cointegrated pairs. There is also a risk that the cointegration is ready to break down.

The bigger problem to me though is you are playing a game that David E. Shaw practically invented. If you find a cointegrated pair with simple statistical techniques and that pair has diverged then the masters of this space are not interested in it or they would have already closed it.

You really just end up trading directional risk for modeling risk and for me I am more afraid of my modeling risk than directional risk.

Directional risk is a much bigger deal if you hold illiquid positions. No one reading this has that problem. You can get out with minimal market impact.

I mean part of the appeal of neutral strategies is to package it in the form of a hedge fund and sell it as a product to accredited investors that already have enough directional and market risk.

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 TrendLineBRK 
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crazymatrix View Post
Ah, maybe MGC against M6E or M6B might be a better fit for me?

I second the notion of currency futures pairs. I've traded many of the pairs available on TOS. Another added feature of pairs is they lend themselves to swing trades as opposed to scalps or day trading which helps if you can't sit at a screen all day (and night). Plus, your per unit risk is lower than a one sided traded.

I will also suggest that pairs trading is not non-directional, you must have a bias as to the spread widening or narrowing. The directional nature of pairs is just different, which segues to my last point. Solve your directional challenges. To be be a successful trader, you must have a directional bias that is correct most of the time.

Everyone has their own approach and finding what works for you takes time. It's like wandering in the desert until one day when you finally walk out. I use support and resistance (trend lines, Fib and pivots) along with general price action. No indicators except the 25 EMA. Here's my NQM19 chart from Friday. I was able to trade both sides from the Globex session to EOD. It was a good day.

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  #17 (permalink)
crazymatrix
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centaurer
I mean part of the appeal of neutral strategies is to package it in the form of a hedge fund and sell it as a product to accredited investors that already have enough directional and market risk.

I started investigating this because I watched a few videos by Anton Kreil. He follows 'global macro' and takes a top-down approach, analyzing geopolitics, countries, sectors, then finally individual products. He claims that the best way for retail traders to be successful is to trade more like an institution: i.e. have a set of rotating hedged positions that offset each other instead of having a single position open with a lot of risk. I'm not planning to outdo those guys at statistics, I just want something a bit more stable.




TrendLineBK
I second the notion of currency futures pairs.

Yes, I'll probably do this -- either two currencies or a currency with gold. I watched an introduction to the new micro contracts today by tastytrade: "CME's New Micro Futures" -- youtube IRKKlAHp92I (I still can't post links). They give an example trade:

 
Code
+---------+----------------------------+----------+
| Product | IV adjusted notional value | Position |
+---------+----------------------------+----------+
| /M6E    | $775                       | +2       |
| /M6B    | $582                       | -3       |
+---------+----------------------------+----------+

IV adjusted notional value = notional value * IV%
Then the ratios of the final positions should be adjusted to make the new notional values match up as closely as possible.

I understand the idea that they want to match up the sizes by adjusting the ratios, but I don't understand where the figures come from. I thought that IV was related to option pricing, so how does IV come into play with futures?

More simply, how can I choose the ratios in a pairs trade?

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 SMCJB 
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crazymatrix View Post
 
Code
+---------+----------------------------+----------+
| Product | IV adjusted notional value | Position |
+---------+----------------------------+----------+
| /M6E    | $775                       | +2       |
| /M6B    | $582                       | -3       |
+---------+----------------------------+----------+

IV adjusted notional value = notional value * IV%

It's difficult to do this with currency futures, as the futures you are talking about are both USD crosses.
So you are in reality just creating a different non-USD cross which isn't really a spread. (Hence IV adjusting them is hogwash)
Additionally since the contracts are not the same size, it gets very dirty quickly.

For example
M6E is EUR 12500 which at current rates (1.1265) is USD 14081
M6B is GBP 6250 which at current rates (1.3032) is USD 8145

So if you buy 2 M6E and sell 3 M6B your position is
2 * (EUR 12500 - USD 14081) - 3 * (GBP 6250 - USD 8145)
which is
Long 25000 EUR, Short 18750 GBP and Short 3727 USD
which is really a
EUR/GBP currency trade (21691 vs 18750) and a EUR//USD currency trade (3309 vs 3727)
probably not what you were expecting.

Now if you did 6E vs AJ that wouldn't be the case. But all the currency micro's are USD crosses.
For what it's worth AJ (AUD:JPY) only traded 348 lots on Friday in the full size contract.

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 TrendLineBRK 
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CME has the notional value for all their contracts - see their website.. Using IV is a twist I've not used before.

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 SMCJB 
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+2 M6E, -3 M6B gives a $3727 or 13.2% mismatch
+3 M6E, -5 M6B gives a $1518 or 3.6% mismatch
+4 M6E, -7 M6B gives a $690 or 1.2% mismatch
So if your goal is to actually have a EUR:GBP currency trade those ratios will make it considerably cleaner.

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 LittleFinger 
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You want:
liquidity: always
small increments of the thing being traded: due to small account and the need to trade multiple contracts so that you can balance out the real dollar value of your spread currencies as SMCJB was explaining.

So I think you should be trading spot forex

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  #22 (permalink)
 centaurer 
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crazymatrix View Post
I started investigating this because I watched a few videos by Anton Kreil. He follows 'global macro' and takes a top-down approach, analyzing geopolitics, countries, sectors, then finally individual products. He claims that the best way for retail traders to be successful is to trade more like an institution: i.e. have a set of rotating hedged positions that offset each other instead of having a single position open with a lot of risk. I'm not planning to outdo those guys at statistics, I just want something a bit more stable.

Global Macro is a good strategy if you have a youtube channel because you can generate a ton of content without being provably wrong on anything.

IMO that is totally absurd advice for an under capitalized retail trader paying retail transaction cost and retail margin rates. There is no reward without risk. The world has more capital and liquidity than anyone knows what to do with. If anything you probably get over rewarded right now for taking directional risk because everyone is so risk averse. A new trader wanting to delta hedge a $4k account is really a perfect example of the current zeitgeist.

The consensus is only good to know what not to do.

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crazymatrix
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SMCJB
So you are in reality just creating a different non-USD cross which isn't really a spread. (Hence IV adjusting them is hogwash)

Thanks for the examples. Is there a situation where I would have to IV adjust futures pairs though? How does that work?




centaurer
If anything you probably get over rewarded right now for taking directional risk because everyone is so risk averse. A new trader wanting to delta hedge a $4k account is really a perfect example of the current zeitgeist.

Thanks -- so I'll just continue improving my directional trading for now (pairs or otherwise) and in the meantime just keep saving up more money.

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 SMCJB 
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crazymatrix View Post
Thanks for the examples. Is there a situation where I would have to IV adjust futures pairs though? How does that work?

Oh yes in many cases. That was what I was referring to when I said this

SMCJB View Post
Do you understand what a Beta of a Stock is? In a common equity pairs trade you would want to structure the trade so you are Beta Flat or Neutral this is very different than dollar flat or share flat.

I just assumed Beta would be a more common explanation to you than IV.

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crazymatrix
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SMCJB View Post
Oh yes in many cases. That was what I was referring to when I said this

I just assumed Beta would be a more common explanation to you than IV.

Ah I get it, thank you! So tomorrow is a new week -- time to try it all out.

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 indiantrader 
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For equity indices futures spreads, there is a white paper on CMEgroup website.
The common spreads are NQ/ES, YM/ES, ES/EMD, EMD/RTY.

NQ/ES -- Buy when Tech stocks are expected to outperform the broader markets. Always check news about FAANG stocks and any good news about FAANG stocks would cause NQ to outperform ES. Intraday difference between NQ%-ES% change ranges from 0-1% but hardly ever more than that. If one buys 1 Long NQ and 1 short ES, each 0.1% difference in spread is about $100.

YM/ES -- YM and ES has different sectoral weightages and thats why the spread between them converges or diverges. When trading this spread, especially check the Tech, Industrial and Utility sectors or their ETFs. Some stocks like 3M,GS,APPL, Boeing have quite different weighatages in YM and ES and thats why the spreads move. On the day of Boeing accident news, ES outperforomed YM by more than 1%. Attaching sector weightages here.

ES/EMD or ES/RTY is spread between large, mid and small cap segments, but not very popular.

NYMEX has some good exchange traded spreads with better liquidity than outrights.
CL/BZ, CL/RB, CL/HO cracks spreads along with calender spreads of CL, BZ,NG, RB are some interesting products.
The NG and HO are seasonal spreads with a peak during winters. CL and Brent spreads are mostly dependent on supply/demand, geopolitical news and its forward curve whether in contango or backwardation.

Spread charts on EOD basis and various other features can be found on https://www.spreadcharts.com/

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  #27 (permalink)
 benedmunds 
New York, NY
 
Experience: Beginner
Platform: Investor RT
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Just wanted to encourage you to keep exploring this option. Iíve been actively trading the RTY/ES spread for a few months now (as a retail trader) and its one of my more profitable strategies. You need to find an edge in it that works for you though, and more importantly a risk management plan that keeps you from blowing up. When spreads run against you the dollar amounts add up quickly.

I keep it very simple. I donít trade it on trend days, so Iím only looking to trade it on days that are mean reverting early in the session.

Then Iím looking for mean reversion based on standard deviations.

And have daily risk limits to prevent myself from taking on too much risk if the spreads run against me too far.




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 SMCJB 
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Houston, TX
 
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Eran Raviv :- Ordinary Least Squares, Least Absolute Deviation and Huber Regression in Pairs Trading

https://eranraviv.com/adaptive-huber-regression/

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 SMCJB 
Legendary Market Wizard
Houston, TX
 
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Optimus Futures :- How to Trade One Index Against Another Using Micro E-Mini Futures

https://optimusfutures.com/tradeblog/archives/trade-micro-e-mini-futures

Little bit "discretionary" for my liking but topic relevant none the less.

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 kareem40 
Dallas, TX
 
Experience: Intermediate
Platform: NT, TS
Broker: IB, Oanda
Trading: ES, MES, MNQ, MYM
 
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Interesting discussion; thanks to all. I have been trading (B/S) NQ-(B/S) YM micros for about a month with very good results. I think the key is to think of probability of touch and/or the different volatility for each contract. If you trade small and are patient you can do well with this spread. They key is not to expect 1/1 risk/reward, trade very small size, and actually add ( yes add) to your losers. And you have to keep your eyes charts most of the time, no set it and forget it here.

Based on my detailed bar by bar reviewed charts, and using the mini contracts, you will get a big loss (not a black swan event, but hurtful) possibly once a year. I have met a guy the have traded the minis ( YM/NQ) successfully for years. He picks up $200-300 per trade, even with the once a year event, he is still profitable.
I do use my own propriety indicator that does help me get in with acceptable draw, but you can do this with % up/down for both pairs. To me, this pair trade seems to be doable, so far. Of course, as we all know in trading everything works until it stops working.
I trade 3 lots on each side, then add 1-2 if the spread gets more "out of wack". So yes I do add to a loser, almost daily. But again still small ( compared to account size). I get out with $50-80 and will at times see a $140 draw. I recently started a journal that shows a couple of those trades ( ). I also daytrade stocks, some Forex and futures using VSA/Price action. Maybe we can work on micro pair trading as a group here.
I hope to see more of this discussion and good weekend to all.
K

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 SMCJB 
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kareem40 View Post
and actually add ( yes add) to your losers

That's actually pretty typical in a mean reversion system. The further you are from the "mean" or "normal range" the greater the probability of a reversion, so the bigger the position you want to have on. The problem occurs in those rare times when it doesn't 'revert' as you have you biggest position on as it goes against you!

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 kareem40 
Dallas, TX
 
Experience: Intermediate
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SMCJB View Post
That's actually pretty typical in a mean reversion system. The further you are from the "mean" or "normal range" the greater the probability of a reversion, so the bigger the position you want to have on. The problem occurs in those rare times when it doesn't 'revert' as you have you biggest position on as it goes against you!

Hi
Thanks for the post. There is so much negative posts and so called "gurus" that tell you to never to add to a loser. For the most part they are right, I do my very best not to on an outright. But for spread trading and the only thing that have minimized the very big loses is that the fact the I insist on closing all, rain or sunshine, by 3 CST. Testing by hand, I have seen $300-500 daily loss ( based on micro size-max of 5). Not many, you just need to be ready mentally for them when they do happen.
K

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  #33 (permalink)
 SMCJB 
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Adding to losers is normally a bad idea and I actually wrote a heavily read post Why you should add to winners and never add to losers a few years back. So why given that post do I think it's both common and okay to add to losers in a mean reversion strategy? Well that analysis assumed a constant probability of the market going up or down. If our hypothesis of a mean reverting price action is correct, this is not the case as the further we get from the mean, the greater the percentage chance that we revert. If I get bored tonite I might write a simulation to try and illustrate this.

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 Jaap8242 
Netherlands
 
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In Stock & Commodities May 2002 I found an interesting article about pairs trading.
https://docplayer.net/6892542-Daytrading-stock-pairs.html

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 SMCJB 
Legendary Market Wizard
Houston, TX
 
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Jaap8242 View Post
In Stock & Commodities May 2002 I found an interesting article about pairs trading.
https://docplayer.net/6892542-Daytrading-stock-pairs.html

Interesting that they are sophisticated enough look at the correlation and relative volatilities but then trade the spread on a 1:1 basis!

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