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Spread / Pairs Trading - the allure and the reality


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Spread / Pairs Trading - the allure and the reality

  #11 (permalink)
 kevinkdog   is a Vendor
 
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josh View Post
Thank you for the post Nicolas.

In short, I am a newbie at this. The sample trade I have taken and the examples presented are really probably the most basic examples possible. The math involved in doing proper trading this way and doing tests for cointegration requires far more than anything I have mentioned, and even understand at this point. I don't have matlab either, which I probably would need.


FWIW: What a couple of long time spread traders have told me is that mean reversion worked well until 5? years ago. Now it does not model as well. I have never used mean reversion in what I do.

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  #12 (permalink)
 
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 kkfx 
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Hi Josh

Thanks for starting the topic.
One needs to determine direction of spread movement like outrights but it has advantages of low volatility, well defined trend/range, upto 95% margin credit in some combination and always holding a hedged position in a market without worrying about stop-loss hunting.
The ES/NQ spreads ratio will be different for different spread traders, some traders adjust it for volatility in addition to the dollar value and some neutralise it with tick-value. In your case study, every tick movement of ES(3 lots) will create $37.5 difference and every tick movement of NQ(4 lots) will create a difference of $20.
The daily ATR of ES is currently 14 and NQ is around 37 so one needs to adjust the hedge ratio based on volatility too.
In case of confusion, its best to use the hedge ratio recommended by CME so one is sure to get margin credit as well.
So in this case its 2NQ:1ES, so tick values are roughly equal and CME offers 70% margin credit for this spread.( see attached picture)
The z-score indicator helps one to identify extreme levels in order to trade mean reversion technique and I remember somebody on futures.io (formerly BMT) coded an autotrading strategy called Ninja-spreader based on z-score.
CME has some good educational material for spreads..here is one pdf manual for index spreads.

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  #13 (permalink)
 
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 josh 
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Most people will probably not truly spread trade. But if readers of the thread can take away anything, it's that intermarket relationships can be useful. Sometimes they are obvious, sometimes they are not. Yesterday is one day in which the relationship between the NDX and SPX was so clearly skewed that it can lead to trading decisions which are clearly favorable.

[IMG]https://cdn.bmcharts.com/screencast/webHSh0sM3k.png[/IMG]

If your overall market hypothesis involved being long intraday, which was easy to do based on the big Summers gap up, a look at how markets were performing after the first 30 minutes or so that buying the NQ or QQQ was not the best option. Look at how quickly it attempts a gap fill. While the S&P was clearly holding strong and making new highs, the NDX was making new lows. The divergence from INDU was even more glaring, as it was particularly strong early in the day. On the other hand, if you were looking to short these new highs, then YM and DIA were definitely not the best products to choose. The Nasdaq was very weak, so shorting it was a much better choice.

So even if you were not looking to spread, looking at how various markets are performing can give a good insight into options you have, instead of deciding that you only trade one product and nothing else. As mentioned earlier, these relationships can change, so it's not so easy as it looks, but I think that some useful ideas can be drawn from these relationships.

As an update on the simulated trade (which I expect on this time scale would typically last a week or two), it is >$500 more in the money since the post this morning showing the trade. This is an example of an intraday spread using the smallest size possible (3ES/4NQ) that has produced a very nice profit, given the small size. One could have traded this at the open and closed now, and it is not a high frequency arb type of trade, but not a swing trade either. It is really using the relationships mentioned earlier, and realizing that, while all markets are higher today, the NQ is the strongest, so it will yield the best bang for the buck.

[IMG]https://cdn.bmcharts.com/screencast/bqixqHgW.png[/IMG]

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  #14 (permalink)
TheDude
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Josh - You start by suggesting you want a market neutral strategy - obviously you've realised spreads do not offer that.

They are market neutral if you are spreading the cash (owned) against a future. Thats a basis trade. Thats different. If you want market neutral as a retail trader, then you may want to look at delta neutral positions such as options.

In terms of spreads - sure you can trade them as an outright with TA - but then like you say, your success will be similar to that of most who rely on TA and totally ignore the real underlying drivers of markets. TA only offers 2 dimensions If only understanding markets were that simple!

OK you'll get reduced margin which is real neat when you get a grasp of position sizing when you get the edge.

Here's a few pointers:

Spreads model much better than out rights. Fly's even better. When they trend, they trend. ie they are more persistent and tend to (not always) have lower vola. Why?

You're trading fundamental differences between demand & supply.
Theres a great video here/futures.io (formerly BMT) from DTN on spreads. Watch it.

TAke a look at RBOB H4-J4. Look at her puke! I noticed a massive premium on J14 the other week looking at the curve. I couldnt see why. Who knows a lot about energy markets? Fat Tails of cousres! I asked him and he kindly explained the fundamental issue of refineries re-tooling this time of year. I'll let him explain if he cares to. Either way, with a traders mindset somthing, that premium difference isnt going to last. Trade it! We're not worried about the price of march or april, just the difference in price. It cant be sustainable. People will buy march rather than april or sell april to march buyers.

Either way, sure as eggs, soon after I discussed this with Fat Tails the spread is coming off as expected. Timing! Good prices are never round for long!

No TA involved. Just common sense.

Also consider seasonals. MRCI.com have some good stuff as do other sites.

Basically you are trading the difference in demand and supply. Sure some spreads will seem to mirror outrights, but if you look at various commdities front month- mid month, agaist mid month- back month you will notice stuff. Spreads can be a good leader to what outrights will do too when you grasp them and think what the curve is saying.

GL

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  #15 (permalink)
 
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 josh 
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Some great posts guys, keep them coming--I will reply to them with comments and questions later in more detail. Just an update right now on my simulated trade. S&P got sold a few minutes ago but the NDX remains firm for the moment, so the spread continues to widen, and the trade becomes more profitable. I do like the fact that I'm not concerned with a single market's direction, but the relative strength of the two.

[IMG]https://cdn.bmcharts.com/screencast/2fr5fG3HV.png[/IMG]

@ Big Mike, I really look forward to the webinar presentation you have coming on this subject. It seems to me that with a trade going into a reasonable profit, it would be an opportunity to do a scale/leg. Just like in an outright trade, I would guess that I could get some profit and better my average by maybe selling one of the NQ contracts at this point, and then if the spread narrows a bit, adding one back in. Or something similar.

Spread traders, is that the kind of thing you would look to do at this point?

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  #16 (permalink)
 
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 kkfx 
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@josh, There has to be some technical indicator to find out when the widening of the spread is ending and is about to narrow again.

Here is my ES/NQ daily chart, ES or the broader market has been outperforming the tech stocks for last one year, over last 2 months NQ has been outperforming on taper talks. Now that FOMC says no taper, the broader markets are now again set to outperform the tech sector till next FOMC.

So Long ES/NQ would be a good swing trade for next few weeks in a 4:10 ratio ( $50 tick value for each).

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  #17 (permalink)
 tflanner 
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I traded Treasury spreads (yield curve) for 10 years (electronically). For 9 of those years I never had a losing month and I made a very good chunk of change. I am an independent trader and I had several friends who had Prop shops with guys that traded nothing but spreads. In total there were hundreds of guys trading these spreads around the clock. It was more or less a mean reversion type trade. Today those Prop shops no longer exit and there are just a few guys left trading these spreads profitably. Mind you in the day I had friends that were 7 figure traders that are no longer trading spreads...in fact one 28 yr old kid made $6 mln in 2006.

Anyway, even when spreads were profitable to trade it was still directional. Why are guys no longer profitable trading spreads. As I stated I traded treasury spreads, Fed action (QE) has not helped and it did change the dynamics of the trade. Also, after the 2008/09 crisis a lot of players were forced out of the mkt and you no longer had a diverse set of players to keep the mkt in check. Most importantly though HFT's have made trading spreads very difficult. It is a speed game and you are constantly missing your 'legs' because they know exactly what you are doing. I used TT Auto Spreader beginning in 2002 and initially it was great. However, by 2008 it was not effective because of HFT's. The exhanges do have a thing called "implied spread" where it executes for you. That was helpful....

Anyway, toward the end I was miserable trading spreads and it trades like an outright anyway and the mean reversion quality of the trade really did not exist anymore. I would not deter you from trading spreads, but if u go down this path I would not scalp it because the HFT's will have u for lunch.

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  #18 (permalink)
 
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 josh 
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Just for posterity, here is an accurate ES/NQ spread plotted on the bottom, with ES on top. ES and NQ are continuous back-adjusted contracts, and the sample used to calculate the ratio is 5 seconds, so this is a very high accuracy spread plot (as opposed to using a daily bar which cannot accurately show the highs and lows of the ratio since they almost certainly came at different times in the day).


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  #19 (permalink)
 
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 josh 
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indiantrader View Post
The daily ATR of ES is currently 14 and NQ is around 37 so one needs to adjust the hedge ratio based on volatility too.

In case of confusion, its best to use the hedge ratio recommended by CME so one is sure to get margin credit as well.
So in this case its 2NQ:1ES, so tick values are roughly equal and CME offers 70% margin credit for this spread.( see attached picture)

The z-score indicator helps one to identify extreme levels in order to trade mean reversion technique and I remember somebody on nexusfi.com (formerly BMT) coded an autotrading strategy called Ninja-spreader based on z-score.
CME has some good educational material for spreads..here is one pdf manual for index spreads.

@ indiantrader, thanks for mentioning the volatility adjustment. I read about this but have not studied much about it yet.

Regarding the CME margin credit, can you refer me to the CME page where you see that? I have searched and found a page at CME Clearing that has performance bonds and cross rate margin discounts but I don't see ES listed, only SP and the other big contracts, for some reason.


indiantrader View Post
@ josh, There has to be some technical indicator to find out when the widening of the spread is ending and is about to narrow again.

Here is my ES/NQ daily chart, ES or the broader market has been outperforming the tech stocks for last one year, over last 2 months NQ has been outperforming on taper talks. Now that FOMC says no taper, the broader markets are now again set to outperform the tech sector till next FOMC.

So Long ES/NQ would be a good swing trade for next few weeks in a 4:10 ratio ( $50 tick value for each).

The issue I have with a z-score or any other technical analysis approach is basically what I mentioned in my first post--why not just apply it to a stock or future by itself? Why spread it? What you are suggesting is to apply TA principles to the spread curve. Z-score just calculates the deviation from the mean, and as the chart I posted initially shows, depending on the time frame the mean is applied to, there is often very little reversion to the mean. So you have a technical reason, and a fundamental reason for the trade. @ TheDude seemed to advocate a fundamental-only approach to his RBOB trade, but then again he's very anti-TA anyway.

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  #20 (permalink)
 kevinkdog   is a Vendor
 
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josh View Post
Just for posterity, here is an accurate ES/NQ spread plotted on the bottom, with ES on top. ES and NQ are continuous back-adjusted contracts, and the sample used to calculate the ratio is 5 seconds, so this is a very high accuracy spread plot (as opposed to using a daily bar which cannot accurately show the highs and lows of the ratio since they almost certainly came at different times in the day).



Note that if you use continuous backadjusted contracts, using ratios will be incorrect for all but the current contract. It might not be wrong by much, but it will be wrong.

That statement also applies to any trading system that uses multiplication or division of the continuous, backadjusted price.

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