Stock Timing Using Pairs Logic

Transcription

1 Stock Timing Using Pairs Logic Perry Kaufman

2 A commercial break for KaufmanSignals.com The strategy shown here is one of three available on KaufmanSignals.com The strategies are fully disclosed. Two of the strategies apply to stocks, ETFs, and futures. This one applies only to stocks and ETFs. Today s presentation is a slightly simplified version of the full program, but is excellent as is. You can receive a working (not protected) TradeStation program on request. The website takes this strategy further, creating dynamic portfolios and processing a large list of stocks and ETFs. The essence will be explained here.

3 It s based on arbitrage Arbitrage is one of the great strategies of all time. In pairs trading it finds two similar markets that are moving apart, then buys the cheaper and sells the more expensive, exiting when the come back together. It can be done with U.S. London Hong Kong gold, or Ford GM Toyota Honda, or Pulte and KB Homes, or even U.S. 10-year notes and the Eurobund. With new technology it s easier but more competitive.

4 Traditional Approach To identify trading opportunities, we can 1. Find two stocks (or ETFs or Futures markets) with correlations between 0.30 and 0.80 (not too strong or too weak) 2. Then use the ratio (or difference) of two prices to find overbought and oversold points Or Use cointegeration (the real method) to decide if these two stocks move in generally the same direction. But we won t. It s unnecessarily complicated. We ll use the Stress Indicator that I introduced in Alpha Trading

5 Example: Ford(top) v GM(middle) using the ratio (bottom) Buy Ford and sell GM when ratio is low But what is high and what is low? And what is normal? Each pair has a different ratio so we can t generalize what value is overbought or oversold

6 Using the Stress Indicator The Stress Indicator is made up of 3 simple stochastic calculations ( raw stochastic ), over a 60-day period The stochastic is important because it doesn t lag Stochastic 1 (F) = (C(today) L(60))/(H(60) L(60)) Stochastic 2 (GM) = (C(today) L(60))/(H(60) L(60)) Stochastic difference (D) D = Stochastic1 Stochastic2 Stress = (D(today) L(60)) / (H(60) L(60)) Ford is oversold relative to GM when the Stress Indicator is below 10 (used as an entry). We will buy there. It is neutral at 50. We exit there.

7 F v GM using the Stress Indicator (Stress=3 rd panel, stock stochastics at bottom, signals top panel)

8 Good, but not good enough The Stress Indicator gives good buy and sell points (under 10, over 90,), but buying one stock and selling another has problems: 1. Profits are frequent but very small (a lot of competition and similarity of price movement), often about 3 /share and you need to trade a large size to offset costs. 2. It may be difficult to execute the short sale 3. Short sales aren t allowed in IRAs. One alternative is to sell the SP (or buy SH or SDS) rather than the other stock, but then profits are even smaller because the index does not move as far (not as volatile) as an individual stock.

9 If you look hard enough If you study the performance of the pairs, the long position is the one that always makes money The stock market has a very strong bias to the upside Even when the market declines, it is fast, and the upward climb occurs most of the time, to different degrees. Then we really want to buy the stock but not go short against it. Our profits per share would be much bigger, more than 30 instead of closer to 3.

10 Traditional results of AMZN-WMT pairs trade using Stress Indicator $P/L AMZN-WMT Pairs trade AMZN WMT cumpl /1/2005 3/1/2006 3/1/2007 3/1/2008 3/1/2009 3/1/2010 3/1/2011 3/1/2012 3/1/2013

11 Typical results of separating longs and shorts a better pattern and larger returns/share 1400 Taking only the long trades for AMZN-WMT 800 Taking only the short trades for AMZN-WMT Long AMZN Long WMT Total Long Short AMZN Short WMT Total Short

12 3/1/2005 7/1/ /1/2005 3/1/2006 7/1/ /1/2006 3/1/2007 7/1/ /1/2007 3/1/2008 7/1/ /1/2008 3/1/2009 7/1/ /1/2009 3/1/2010 7/1/ /1/2010 3/1/2011 7/1/ /1/2011 3/1/2012 7/1/ /1/2012 Apple v SPY ($PL) the early loss in AAPL is easier to take than the loss in SPY (better with QQQ) AAPL SPY Total

13 Apple trading signals Stress in red at bottom

14 Returns per share in $ Overview of results information ratio and profits per share Symbol OXY CAM GIS TLM MT SLB NE EOG BAX WMB APD HAL BIDU NEM RS CLF SNY BHI DVN SE TS MRO CVX MON ADI HES CSX K TSM VE UNP QCOM DE HUM CPB CAT GTAT LEN M MTU PKX NOC HSY NEE ALK TGT AEP PCG JNJ KMB ETR CCC ITW MO ALXN SBUX NSC YUM LCC WM NVS SPWR GM VZ KO BRCM KEY GE PAYX SEE JBLU WFC AAPL TM IBM APC BIDU AMGN EOG APD C DVN ATI ESV CCL BAX PEP MT SRCL NFLX MSI HES ABC XLNX HD ABX MON RS DE GIS GGB K GILD AA PKX TOL FTI DAR DUK ARMH TJX NOC GPC BMY TGT UNH ETR CLX CVS AEP TXN KMB SYMC GPS MCD RAI RSG CNP AAMRQ CAG UAL ED WM PSA SPWR NVS AFL KEY HA SCHW DD SEE PAYX BAC MRK Return ratio of 218 long stock positions (65% profitable after $8 cost) -1 Profits per share 218 long stock positions (FB is on the right), $0.30 median return

15 Not all stocks work When you arb against the S&P (or QQQ, IWM) not all stocks work Some don t track with the index because they may not move with the economy in the same way For example, during the crisis of 9/11/2001 the market plummeted except for defense stocks, which went up Raytheon (RTN) jumped 100% from 9/10 to 9/28 if we d only known! Trying to figure out (fundamentally or intellectually) which work and which do not is a useless exercise Running the strategy against each stock and using the one s that work is much easier and just a valid

16 But we can t trade without risk protection What if we have another 2008 and we re sitting with a long portfolio while the market tanks? What if we are long Enron or another company that just collapses?

17 Protecting the downturn Unfortunately, it s not safe to always be long We can protect our long stock positions by selling SPY (or buying SH or SDS) when the trend of the index turns down (or selling QQQ or buying QID) In our simple version we use a 60-day moving average and hedge 50% of the risk when that trend turns down. In the full version we use 3 trends, 30, 60, and 120 and hedge 1/3 of our 50% hedge on each trend. The amount of the hedge is: Stock size x (20-day ATR of the stock price divided by the 20-day ATR of the SPY price) The total hedge size is the sum of the hedge amounts for all the open stock trades Add and remove hedges as your positions change or when the trend of the hedge index changes.

18 Protection Using the Trend of SPY Only take long stock positions and sell SPY when the SPY trend is down (center panel)

19 Risk calculation using 3 stocks

20 SPY hedge size

21 Stop-loss I hate stop-loss orders, but they are necessary in this strategy If we are long and we ve picked an Enron, the price can keep falling while the SPY is still in an uptrend Then we would never exit the trade because it is always oversold compared to the SPY We never hedge because the overall market is still in an uptrend Therefore, we use a 15% price stop from the point of entry, just for an emergency In the long run, no stop is best, but in the short run, an Enron can end your trading career

22 Sample good results AMZN v QQQ Total $P/L 400 AMZN v QQQ Number of Shares Traded StockPL IndexPL CombPL Long AMZN Short QQQ

23 More good results 6000 HES v SPY Total $P/L 400 HES v SPY Number of Shares Traded StockPL IndexPL CombPL Long HES Short SPY

24 Other results 2500 AFL v SPY Total $P/L AET (Aetna) v SPY StockPL IndexPL CombPL StockPL IndexPL CombPL

25 Summary of trading rules Decide on a pair to trade: AAPL v QQQ Calculate the Stress Indicator (SI) for that pair Buy the stock when SI < 10 Exit the long stock position when SI > 50 Calculate the 60-day moving average of QQQ If the trend of QQQ is down, hedge the stock position with QQQ equal to the risk of the stock using the 20-day ATR of each Exit the hedge when the stock position exits, or exit the hedge when the trend of QQQ turns up Do not trade stocks under $3 All trades are done on the next day s open

26 A fast way to build a portfolio The objective is to keep the portfolio filled with the most volatile and (potentially) profitable markets Assume we scan 200+ pairs and want to choose the most likely to succeed. Then, for each pair o o o Calculate the return ratio over the past year (250 days) Calculate the recent 20-day return or the recent 20-day price volatility Identify whether this pair has an active trade Sort the information in order of the highest long-term ratio (at least 2 years) and largest recent profits (60-90 days) Discard any market with a negative ratio Discard any market with no current position Start from the top and add markets until the portfolio is filled or until you run out of stocks that qualify (in a bear market you may not get any trades because there may not be short-term profits) Using a strategy with a high chance of success, and eliminating those markets that do nothing, will allow you to beat the index even in an bull market.

27 Maximizing your returns All performance records posted by professionals are compounded In order to get those results you ll need to track your performance and chance the size of your position when you get a new trade If you are up 10%, then the next trade should have a size that is 10% bigger (size x ( )) If you are enter a losing period, keep the same size as your last trade. If you reduce size, the time to recovery is much longer.

28 Sample portfolio returns (simulated)

29 KaufmanSignals.com Provides three robust strategies, applied to o o o 220+ stocks, 60 ETFs, and 60 futures: Timing (pairs logic) for stocks, sector rotation Divergence for 220 stocks, 60 ETFs, and 60 futures Trend for stocks, ETFs, and futures Provides a variety of dynamic and fixed portfolios of different investment sizes for stocks, ETFs, and futures Provides all signals in all markets each day before the markets open (8 am New York) Tracks performance Provides value-added analysis monthly Available by subscription, but there is lots to read if you register for free Check out our new website

30 Any questions or comments? Contact me at Copy of presentation and TradeStation program available on request