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Spread / Pairs Trading - the allure and the reality
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Spread / Pairs Trading - the allure and the reality

  #21 (permalink)
Market Wizard
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Yikes

I had an awful typo in the post above. Completely changed the meaning. It has been corrected.


If anyone does not understand my post above, please ask.

If you have any questions please send me a Private Message or use the futures.io "Ask Me Anything" thread
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  #22 (permalink)
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@TheDude , thanks for your reply. After having some time to look in depth, here are my responses/questions:


TheDude View Post
Josh - You start by suggesting you want a market neutral strategy - obviously you've realised spreads do not offer that.

By market neutral I meant that the profitability of the trade does not depend on a long/short direction. The trade will be profitable if one product (or group) is relatively stronger or weaker than another product (or group). Is this not accurate to say it's market neutral?


TheDude View Post
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!

Definitely I think understanding what drives a market is important. But for a short term trade, the driver is often not fundamental or explainable at all, and even for longer term trades to some degree this is true. Sometimes the fundamental driver is clear cut, but in today's markets much of the activity on an intraday basis is not created by anyone with a real fundamental reason. Would you disagree?


TheDude View Post
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.

(edit: I am looking at the chart at the moment but I don't see it apparently. What day was this?)
Great example--so you're saying that you saw H4 was much weaker than J4, got some info from our main man FT, and then felt that a reversion was imminent, so you bought the H4/J4 spread. Right? By the way, you plot the ratio of H4/J4, or the difference? I would think the ratio would be a more accurate way, but maybe with the same product and such similar prices, a change in percent will roughly model the absolute change in price.

Do you just scour various markets and look for anomalies like this, or do you have a set list of markets you track, or...? In other words, how did you find this inefficiency?


TheDude View Post
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.

Excellent, thank you again for the reply, this will be helpful.


Last edited by josh; September 19th, 2013 at 01:09 PM.
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  #23 (permalink)
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josh View Post
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?

Perhaps because there is much more chance that a cleverly-built spread be mean-reverting than a given security. And there are statistical tools to check this capacity of mean-reversion. On this topic, you could refer to last book from Ernst P. Chan.

Nicolas

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  #24 (permalink)
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Nicolas11 View Post
Perhaps because there is much more chance that a cleverly-built spread be mean-reverting than a given security. And there are statistical tools to check this capacity of mean-reversion. On this topic, you could refer to last book from Ernst P. Chan.

Nicolas

Thanks Nicolas, I have read some of his stuff online but I will get the book (and MATLAB?!) and check it out!

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  #25 (permalink)
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@josh ,

I would like to clarify that I have never traded spread. I am just interested in the subject.

R could be a free alternative to Matlab.

Nicolas

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  #26 (permalink)
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josh View Post
@TheDude , thanks for your reply. After having some time to look in depth, here are my responses/questions:



By market neutral I meant that the profitability of the trade does not depend on a long/short direction. The trade will be profitable if one product (or group) is relatively stronger or weaker than another product (or group). Is this not accurate to say it's market neutral?



Definitely I think understanding what drives a market is important. But for a short term trade, the driver is often not fundamental or explainable at all, and even for longer term trades to some degree this is true. Sometimes the fundamental driver is clear cut, but in today's markets much of the activity on an intraday basis is not created by anyone with a real fundamental reason. Would you disagree?



(edit: I am looking at the chart at the moment but I don't see it apparently. What day was this?)
Great example--so you're saying that you saw H4 was much weaker than J4, got some info from our main man FT, and then felt that a reversion was imminent, so you bought the H4/J4 spread. Right? By the way, you plot the ratio of H4/J4, or the difference? I would think the ratio would be a more accurate way, but maybe with the same product and such similar prices, a change in percent will roughly model the absolute change in price.

Do you just scour various markets and look for anomalies like this, or do you have a set list of markets you track, or...? In other words, how did you find this inefficiency?



Excellent, thank you again for the reply, this will be helpful.

I really should try and stop posting if I havent read the full thread I should also stop posting when Im overly tiered. Sorry for the confusion....

I trade commodity calendar spreads usually holding for a few days or weeks - so they aren't really market neutral. They will tend to drift in the same direction as the front month if you're looking at the first few spreads or so. I see now though that your looking at ES-NQ which is kind of market neutral in that your trading the over/under performance of one index against the other rather than the direction of the stock market. This trade could offer great opportunities for long term trades around economic cycles. From memory, the tech sector outperforms the market in the early recovery stages. I dont trade inter commodity spreads because I got my fingers badly burnt in a live cattle-hogs trade. The the short went sky high, the long puked! Im scarred from that! Cals are nice and simple. 1-1. No ratios or anything.

I didnt realise you were looking at trading these intraday. To my thinking, any spread or market is going to be driven by news and sentiment primarily. Intraday, its mostly trends caused by people moving in and out of positions and trading round positions. So a daily trend will persist for longer and is easier to get a grasp of. I intraday outrights. Nothing wrong with day trading spreads. Loads of people do.

As for RBOB:

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As you see, it starts breaking out of a range around the 9th, and really gets going on the 16th Margin is $550 init, $500 variation. If you entered on the close of the 9th, you'd have just under $4000 on a 10 lot taking very little heat. The spreads not that wild because your trading the 2 adjacent months. If you traded Jan-April, you'd probably have more, but obviously the margin may be more.


I found it here:

Open Contracts Spectrum

Look at Gasoline. There's still a massive distortion in April. I really like this page for looking at commodity curves. Hogs wheat and Nat gas are all looking a bit funky at the moment. Its also a good sanity check - you want to be short spreads (narrowing) contango markets, long (widening) spreads in backwardation. Same idea as trading with the trend.


Last edited by TheDude; September 19th, 2013 at 04:52 PM.
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  #27 (permalink)
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@josh

Here is the margin credit information about ES vs NQ

http://www.cmegroup.com/trading/equity-index/us-index/e-mini-nasdaq-100_performance_bonds.html

Check equity index and select ND-nasdaq, it will show synthetic pairs, the ratios recommended by CME and the margin credit offered by them.

Regarding z-score, it s mainly used for pairs that show fairly good mean reversion.

The spread pairs like synthetics (ES:NQ,CL:BRN,Corn:wheat), calenders have a tendency to diverge and form a trend...its these spread pairs for which TA indicators can be applied.
The spread pairs like butterfly, condor, synthetic interexchange( CL vs WBS-ICE or cash vs futures or interexchange corn/wheat spreads) show a tendency towards mean reversion where z-score works well.

I am still training with Peter Hamby (SpreadProfessor), but my understanding is this.

High correlation, High co-integration---->trade for mean reversion
High correlation, Low co-integration-----> trade for diversion/widening of the spread pair

Basically, the opportuniy for a spread trade arises when the correlation is out of place temporarily, so pairs with correlation coefficient of 0.95 and less but more than 0.85 are favourable pairs.

There is one webinar on Advantage futures website on trading spreads.
Trading the European Yield Curves - YouTube

He describes the spreads construction like TED and butterfly Vs Butterfly where most of the charts look like a horizontal channel and trades are taken at extremes of the ranges and target the mean.

Correlations can be studies at Commodity Systems Inc. ? EOD Market Data and Trading Software by subscribing to the correlation lab service and it shows quite interesting findings eg. Light sweet crude and brent have just 61% correlation for the last 2 years

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  #28 (permalink)
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@TheDude

I checked the link to your page but it seems the spike in open interest you showed in J14 does not seem to be there on CME page.
I am attaching the OI list here.

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  #29 (permalink)
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TheDude View Post

As for RBOB:

...


I found it here:

Open Contracts Spectrum

Look at Gasoline. There's still a massive distortion in April. I really like this page for looking at commodity curves. Hogs wheat and Nat gas are all looking a bit funky at the moment. Its also a good sanity check - you want to be short spreads (narrowing) contango markets, long (widening) spreads in backwardation. Same idea as trading with the trend.


@TheDude , His Dudeness, duder, El duderino,

You always have the greatest links, thanks for that. In your trading, how are you dealing with seasonality? are you taking advantage of it?, trying to avoid it? ignoring it?

"If I agreed with you, we'd both be wrong."
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  #30 (permalink)
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indiantrader View Post
@TheDude

I checked the link to your page but it seems the spike in open interest you showed in J14 does not seem to be there on CME page.
I am attaching the OI list here.


It's not OI, it's the all important price!!

Look how prices are in a fairly even state of carrying charge from Jan to March, then there is a massive jump in the price in April, where the curve goes into backwardation to the end of the curve. Thats what the Scarr Trading page is showing - prices along the curve, not OI.

I've never really used OI much in spread trading, but now you mention it, it could be a great thing to look at combined with COT data perhaps?

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