Pair trading / Hedging / Market neutral (?)

Water Cooler Investing
#1

Hello guys,

I have decided to start trading and i have talked with a person who uses “spread/pair trading” as he said. His idea is that he finds pairs that are highly correlated, calculates a multiplier (i.e Commodity A/Commodity B), gets the mean, min and max of that multiplier and then trades it by going long on one instrument and short on the other hoping the pair will revert to the mean. He claims that this brings profits irrespective of market direction i.e he is concerned with volatility instead of direction.

I have been trying to get my head around this but it’s not clear and for different reasons I would prefer not to bother him again. How would you know which instrument drives the multiplier’s trend away from the mean? How does that make you profit no matter the direction of the market? It seems like a confusing fusion of hedging and mean reversion strategy. I have tried looking at the CFA curriculum and the beta/dollar neutral strategies but nothing seems to be a close match to what he described.

Is there anyone experienced in trading that knows what the guy is on about? :slight_smile:

Thanks

Bullfrog

#2

The easiest thing to do would be to google and research this strategy. See example here:

https://www.investopedia.com/university/guide-pairs-trading/pairs-trade-example.asp

Understanding the risk/return from this strategy is something you’ll have to look at in detail.

#3

“The market” is the overall stock market, or other market. For instance, you might assume Brent Crude Oil should always trade at 1.1x the price of WTI Crude Oil. If commodities in general go up or down, your strategy is not affected.

#4

Ohai,

Just to follow your example. Imagine the mean multiplier between WTI and Brent is 1.1x. If the current multiplier is 1.7x then this strategy would command to sell. How do you “sell” though? 1.1x or 1.7x or any multiplier is driven by two variables; how do you decide which one is outside the strategy’s lines? In other words, how do you know that Brent is too expensive and not WTI too cheap?

thanks

#5

Are you trolling me? You care about the relative prices between the two assets. So, if you buy the one that is relatively cheap and sell the one that is relatively expensive, it doesn’t matter.

#6

You should focus on cointegration instead of correlation. I tried it once to find highly cointegrated stocks (preferably from the same industry), calculate the average spread between the two assets and as soon as the spread broke out of an envelope (upper and lower bound) I opened a long and short position ‘hoping’ the two stocks move back to the initial spread.

I built an R script for it and automated the whole process but unfortunately it didn’t work out :wink:

Happy to discuss this topic though