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Pairs trading


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Pairs trading

  #1 (permalink)
Berlin, Germany
 
 
Posts: 7 since May 2019
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Pairs trading

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)
Legendary Market Wizard
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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)
south africa
 
 
Posts: 169 since Dec 2018

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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  #5 (permalink)
Legendary Market Wizard
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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)
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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)
Legendary Market Wizard
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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)
Legendary Market Wizard
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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)
Berlin, Germany
 
 
Posts: 7 since May 2019
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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)
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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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