Tip # 4 – Review The Correlation Chart
Investopedia defines “correlation” as a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management. Correlation is computed into what is known as the correlation coefficient, which has value that must fall between -1 and 1.
A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.
But note that correlation is not causation – ie rising ice cream sales does not necessarily increase the number of shark attacks (see figure below).
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Presentation by Geoffrey Hossie of Pairtrade Finder to the Marbella Business Institute, 24 February 2017.
An introduction to Pair Trading and Why It Matters To You.
Tip # 3 – Analyze Your RSI Chart
Technical analyst J. Welles Wilder created the Relative Strength Index (RSI) as a tool to measure the strength or weakness of the closing price series of a security over time. It is a measure of both velocity (speed!) and magnitude (distance travelled) of price changes and can identify stocks that are either overbought or oversold.
The Relative Strength Index is calculated as RSI = 100 – 100/(1+RS). RS (Relative Strength) is usually calculated as the exponential moving average of daily gains/exponential moving average of daily losses during a defined time period. The standard time frame is 14 days. If losses over that time frame are close to 0, then RS approaches infinity, and the RSI approaches a 100 reading (moonshot!).
If you don’t follow the maths, don’t worry. What you need to know is that when the RSI is exceeding 70 or below 30, then the security in question is entering “overbought” or “oversold” conditions, meaning the price has moved very fast and covered a lot of ground in a certain direction, and may be due a breather. Hence, the RSI is a momentum indicator (oscillator) that we use to help us identify turning points in price action.
For the purposes of pair trading, we look at the RSI of the Price Ratio of security A/security B as opposed to the price action of an individual security. It is a closing price series over time and hence the RSI can be applied.
Pay Attention to the Foot on the Gas Pedal:
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Tip #2 – Price Ratio Analysis
Pair trading often succeeds or fails based on price ratio analysis, which is the core of the system. The maths are simple: in two correlated stocks what is the ratio of stock A to stock B (price A/price B)? The closer the stocks are in price, the closer the ratio will be to 1. For example, if stock A is trading at $55/share and stock B is at $58/share, the price ratio is 0.95.
Watch For Changes in the Current of the Stream:
Correlated stocks, and to a great extent co-integrated stocks, over time tend to move up and down together like two fish swimming side-by-side. That’s a logical outcome of the mathematical relationship, which reflects the fundamental reality. The same economic factors, such as regulatory environment, macroeconomic trends, overall customer demand etc. affect both stocks similarly. Using historical data and pair trading software, a trader can establish a solid baseline for analysis. The longer the trading history of the pair, the firmer the backtested trading parameters derived from past price ratio deviations may be.
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Tip #1 – Determine Why the Trade Signals for a Pair Trade Were Generated
So things are going well in your quest become a profitable equity pairs trader. As a result of following our 3-Hour, 11-Lecture Pair Trading Video Course, you have:
- Installed Pairtrade Finder v3.27 on your PC and ensured you have a clean internet connection to access Yahoo! Finance data and keep your My Watchlist pairs updated both EOD and intraday;
- Created groups of equities that are in the same or similar industries and sectors, have market capitalizations of at least $1 billion, and have a daily traded share value of at least $5 million. You can use our pre-loaded Excel sheets for this task, and copy and paste the tickers for each pre-filtered industry grouping into the Create Group entry screen;
- Generated the results of your backtests using your preferred parameters (we use an Entry stretch of 2.7 sd and an Exit stretch of 1.0 sd and always backtest over three years or more, looking for at least 8-10 trades in the pair history, and initially use only one Entry Layer);
- Screened the backtest results by your preferred parameters (we like to see at least $500 avg profit per trade using $10,000 per leg, at least 80% winning trades, and any largest losing trade that is no more than 50% of the avg winning trade);
- Saved the resulting pairs to My Watchlist so that they can now be updated both EOD and intraday to generate Trading Signals;
- Configured your email address into Pairtrade Finder to allow you to receive Trading Signals by Email if you desire.
Below is a sample backtest from a good-looking pair EPAM/MANH (EPAM Systems, Inc. and Manhattan Associates, Inc.):
Click to view full version
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