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A Presentation by AlphAmerica Asset Management and PairsTrading.com on. Pairs Trading: Leveraging Expanding Technologies. Prepared by: Douglas S. Ehrman For more information, please contact us at 312.961.7063 or info@experityfund.com. Pairs Trading is the synthesis of 3 basic elements:.

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A Presentation by AlphAmerica Asset Management and PairsTrading.com on

Pairs Trading: Leveraging Expanding Technologies

Prepared by:

Douglas S. Ehrman

For more information, please contact us at 312.961.7063 or info@experityfund.com

the elements of pairs trading overview
Pairs Trading is the synthesis of 3 basic elements:The Elements of Pairs TradingOverview

The Market Neutral Element

Market neutrality is central to pairs trading because it drives how trades are built and analyzed, it defines relative risk metrics & it serves as the basis for the overall trading strategy.

The Arbitrage Element

Arbitrage is central to pairs trading because it provides the framework for the success or failure of a trade, and, therefore is the basis of absolute risk management.

The Technical Analysis Element

Technical analysis is central to pairs trading because it provides many of the tools by which a trader may make decisions about both the quality and the timing of any potential trade.

the market neutral element
Many types of neutrality must be considered:The Market Neutral Element

Sector or Industry Neutrality

A pairs trade that crosses sector or industry lines may be statistically attractive, but each leg of the trade is acted on by different market forces that may affect the ultimate success of the trade.

Market Capitalization Neutrality

Pairing stocks with significantly different market caps may leave a trade vulnerable to regular market rotations.

Beta Neutrality

Pairing stocks with significantly different betas builds a market direction bet into a trade where it may not be wanted. While total beta neutrality is very difficult, a pairs trader must always be aware of the betas of the two stocks he or she is pairing.

the market neutral element1
Share Neutrality vs. Dollar Neutrality:

Example

Stock A - $10 Stock B - $5

Dollar Neutral Pair

Long 1000 Shares A = $10,000

Short 2000 Shares B = $10,000

Share Neutral Spread

Long 1000 Shares A = $10,000

Short 1000 Shares B = $5000

Market Falls 20%, Stock A Outperforms

Stock A - $8.50 Stock B - $4

Long 1000 Shares A = $8,500

Short 1000 Shares B = $4000

Net = Loss of $500

Long 1000 Shares A = $8,500

Short 2000 Shares B = $8,000

Net = Profit of $500

The Market Neutral Element

Share Neutrality

The classic “spread” trade

Not really market-neutral

Creates situations of proper analysis while still losing money

Dollar Neutrality

Pure “pairs” trade

Assures proper analysis leads to profits

the arbitrage element the importance of correlation
ApplicationThe Arbitrage ElementThe Importance of Correlation

Over time, the price ratio stays very close to its historical average, in this case, about 1.5.

If ABC and XYZ are highly correlated, the ratio of their two prices will be very stable when considered over a long period of time.

the arbitrage element the importance of correlation1
ApplicationThe Arbitrage ElementThe Importance of Correlation

There is oscillation around the average historical price ratio.

Despite the high level of correlation, there will be a degree of fluctuation when the price ratio is considered across a shorter period of time.

By entering a trade at an extreme, there is a high probability that the direction of the ratio will reverse and the pattern will repeat.

This process is called mean reversion.

the arbitrage element mean reversion
ApplicationThe Arbitrage ElementMean Reversion

Market neutrality eliminates most of the affects of movements in the general market.

Correlation analysis compares the strength of the relationship between the long portfolio and the short portfolio.

In a properly constructed portfolio, mean reversion occurs when the long and short portfolio return to their historically average relationship.

Mean reversion is an example of relative-value arbitrage which is based on an implied or assumed convergence of a pair’s price ratio back to its historical average.

the technical analysis element non perfect pairs
The Technical Analysis ElementNon – Perfect Pairs

In most cases, pairs are not as “perfectly” range bound as in the below example.

The pair must be considered as a single trading unit.

Considering the price ratio creates a single dynamic, dollar-neutral vehicle to which the appropriate indicators are applied.

Technical indicators, when applied to the pair, give the trader the tools needed to gage proper entry and exit points; they dictate the timing of pairs trades.

the investment process
The Investment Process

Model or Screening Tool

The increasing availability and decreasing cost of technology is allowing more and more traders to easily begin trading a pairs strategy.

Fundamental / Technical Overlays

Additional Statistical Filters

PAIRS PORTFOLIO

analyzing similar commodity types
Futures with similar characteristicsAnalyzing Similar Commodity Types
  • Futures on Stock Indices
  • Energy Complex
  • Agricultural commodities
  • Interest Rate Futures
  • Precious Metals
  • Currencies

Futures with inverse relationships

  • Gold and the U.S. Dollar
  • Stock Index Futures and Interest Rate Future in Certain Economic Environments
  • Some Currencies
natural correlation1
Short-term Spread Trading of the Same CommodityDifferent Months of ExpirationNatural Correlation
  • Always move in the same direction
  • Move at different rate
  • Constantly create short-term trading opportunities
  • The range is clearly defined
  • Easy to identify entry and exit points
  • Obvious risk management techniques

December Gold – August Gold