Dear ncube,
If we trade pair trading as positional then it must be in Futures...so we use cash data to find the pairs and zscore then enter in futures am right?How you entry take at morning ?is it same way as intra using 1st 30 minuits or any other way?Also please share the steps to balance lots as lot qty is different....
If we trade pair trading as positional then it must be in Futures...so we use cash data to find the pairs and zscore then enter in futures am right?How you entry take at morning ?is it same way as intra using 1st 30 minuits or any other way?Also please share the steps to balance lots as lot qty is different....
2. I will place Limit BUY/SELL orders at previous day closing price and wait for either 1 of the trades to get executed, if only one gets executed at the limit price I modify the other to market and execute the trade. This will to some extent ensure we got the price at the zScore level.
3. Yes, we need to use Futures to take trades but use the cash segment closing prices for our zScore calculations and trading. Actually I use futures for short trade, and use cash for the long trade as it allows me to dynamically maintain the hedge ratio. However if the lot size of long trade is achieved by futures then I take futures long trade and the difference in cash.
How to measure the hedge ratio for pair trading:
1. The classic approach to find the hedge ratio is to run a linear regression on the 2 stocks for the period say 20 days. What actually the linear regression does is that it provides a mathematical formula in the below format which explains how the 2 stocks X & Y prices are related in the last 20 days.
Y(Stock1 price) = (Some constant) + Beta * X (Stock2 Price) + (some error value)
2. The important parameter in the above formula is Beta. So using Beta we can calulate what should be the size of each stock for proper hedging. Lets say the beta value it 0.5, the the formula can be simplified to:
Y = 0.5 * X (ignore constant & error)
This means if we buy 100 shares of X then we need 50 shares of Y for hedging.
In most of the books and articles that you read on pair trading, you may find that once the trade is entered one just waits for the Zscore to mean revert, however I find this not a correct approach as there would be lot of drawdown if the pairs do not start to mean revert immediately. Hence I prefer to manage the trade daily using the rolling beta approach. I.e I run the linear regression on the 2 stocks every day and measure the stock daily position size based on the new beta value for that day, I will then sell or buy more of the Long stock so that the hedge is maintained on daily basis.This helps in reducing the volatility in the portfolio and drawdown is reduced. And once the zScore mean reverts I will close both the trades.
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