TRADING TECHNIQUES
Using Volatility And Correlation
Daytrading Stock Pairs
by Mark Conway and Aaron Behle
Tired of trading Level II quotes and one-minute charts? Try a market-neutral
strategy.
It can take years of experience to discover
one unique insight to exploit that can consistently pull money out of the
stock market. Most traders have a bias as to market direction and position
themselves accordingly; however, market-neutral strategies are becoming
popular for those who are tired of trading on the gerbil wheel of Level
II quotes and one-minute charts.
Pairs trading is a market-neutral strategy where a long position in
one stock and a short position in a correlated stock are taken simultaneously.
The profit principle of the trade is based on mean reversion - that is,
two stocks that normally trade in the same direction become temporarily
uncorrelated and eventually will revert to the mean.
All of the published work on pairs trading relates to positions held
over several days or as much as several months (for example, mergers and
acquisitions). However, recent changes in margin requirements give the
daytrader access to as much as 4:1 intraday buying power, which is perfectly
suited to intraday pairs trading.
This article presents a complete strategy for daytrading stock pairs.
First, a definition for the spread is presented, along with a visual TradeStation
indicator. Second, the volatility bands will be calculated to determine
when a pairs trade is initiated. Third, the complete entry and exit rules
for the intraday pair trading system are defined. Finally, examples are
shown, complete with performance summaries.
The allure of pairs trading is that it is a strategy with little risk;
however, no stock is immune to the risk of a trading halt or an earnings
warning. As with every other trading system, specific entry points, exit
points, profit targets, and stop-losses need to be defined. First, I'll
review the factors required for calculating the spread and the upper and
lower bounds known as volatility bands.
THE SPREAD
The spread is a separate plot (see Figure 1) that compares the difference
in price between two stocks and plots this value as a black line in real
time within the volatility bands. The red line is the upper volatility
band, and the green line is the lower volatility band; these bands are
computed at the beginning of each trading day.
Figure 1: THE SPREAD. It's a simple calculation that compares the
difference between two stocks.
When the spread line touches the upper band, the stock in the top panel
(stock A) has become overvalued relative to the stock in the lower panel
(stock B) - a condition indicating that stock A should be shorted and stock
B should be bought. When the spread touches the lower band, stock A has
become undervalued relative to stock B. In this case, stock A should be
bought and stock B should be shorted at the same time.
The spread can be calculated according to the following formula:
Spread = (LastA/CloseA) - (LastB/CloseB)
Divide the last price of stock A by its closing price yesterday, and do
the same for stock B. Subtract the difference to obtain the current spread.
...Continued in the May 2002 issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the May 2002 issue
of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2002, Technical Analysis, Inc.
Return to May 2002 Contents
