ASX Stock Pairs Trade Journal

I look forward to your posts and will be following this thread with interest.

 

I would also like to thank you for your previous post as it raised a lot of interesting discussions. I have been quite interested in what I have been learning of Pairs Trading over the last couple of months and will keep an eye on this thread to learn more - from all participants!

 

Look forward to it, Pairs Trader. Would you also give an update on the RIO/BHP thread?

While I agree with the principle of pairs trading and see some of its advantages, I have a lot of problem accepting it being called arbitrage. Arbitrage by definition is risk-free profit. Pairs trading is not zero risk, although it does neutralise to some extent certain categories of risk.

 

Pairs trading negates some systematic risk common between the two components and leaves the risk factors not common to both including non-systematic events. In other words the macro risk factors can be eliminated to a degree (if the stocks have a high corelation to these factors) and what you are trading is the differences in the stocks, albeit with more risk than if you were just trading one. I would say that at times it can be more risky - I would be interested how you close out your positions, exercise money management, judge when you should get out, etc considering your position is in effect two trades not one.

What criteria would you use for a pairs trade? It does have its advantages.

 

When trading pairs, how important is it that both stocks are in the same industry/sector?

 

Not that I'm a professional at this, but generally, they will be, as a close correlation is required.

Pairs Trader averages down exponentially (by the looks of his last thread), his trades, which is a very interesting strategy and will work most of the time. But as I asked in the thread, at what point, do you cut it? Sometimes, the spreads on certain pairs will blow out and I know of one big trader who did his azz when this happened.

 

Thats easy. You now have two trades that can fail on you; not just one. These stocks tend to move with retail numbers I would say although I have never traded them. If you do this going on my previous assumption although the Australian retail risk is almost cancelled (theoretically) if the stocks have a high correlation to this risk factor there are other issues. What if it was announced that DJS is the front runner of the sector? and at the same time HVN announces a profit downgrade? (can happen in reporting season pretty quickly). Suddenly you have a loss on both of these trades. Notice how those announcements have very little to do with the overall retail sector.

Each stock has a number of risk factors. By going long/short you are trying to neutralise the ones common to both, and at the same time your trade is only with the risk factors that are not common - these are usually more unpredictable however. RIO announcing a debt burden would of been a huge example and BHP announcing they have none if you have done your previous trade before the announcement.

Risk is not really measured by this anyway. It's about the size of the position, market conditions, and a lot of other factors. The problem comes of course when people don't realise all the risk factors that they are indeed getting a exposure to when trading.

 

I gather by your lack of response to this question in either thread, you don't cut it, full-stop?

Good thread though. Interesting to follow. Thx.

Aleck, yes, good point, more worthy points to this thread. Pairs trading is not risk-free and at the wrong time, you will get killed on both sides. Hence, my original question.

 

Could you please elaborate as to why you took this trade?

 

MRC & Co.
I asked the question precisely because I saw a few pairs which are closely correlated yet in totally different industries.
Eg. Check out LNN and CSL, its in the high 80s.

PairsTrader
Thanks for your response.

 

PairsTrader.

How far back do you look when measuring correlation?
A few months? Years? Combination of both?

 

What about the unexpected though, as in the case of Aleck, would you simply hold and assume eventually, they will come back to a mean, even though the fundamentals of the pair have obviously altered?

Personally, my account leveraged many times over would not be a problem, if I was comfortable with my directional trading and employed tight stops on individual trades. It's how futures scalping works.

But I like the general premise of your trading, just not the no stop part, correlations come and go and if it's thought this may be the case due to a change in the fundamentals of the correlated pair, I can't see why averaging further offside would be wise, in comparison with simply cutting the loss there and then.