Friday, June 09, 2006

An intraday variation to Pairs trading, my style of trading


It took me a while to find a strategy that worked intraday that would give me signals for high probability trades to occur. I use to try to trade stocks which had very little correlation with each other, and I use to only watch a couple charts,,,that was a waste of time, however I learned chart patterns and high probability setups.
To know how to trade, you must know how the market is connected. I suggest looking at the market from a top down approach and then narrow it down to a few products to trade.

1.You must realize that the futures like the ES,YM, and NQ are your greatest indicators intraday. (you may also may take note of the EURO and Bonds,,however,,these often react to whatever the futures are doing)

2.The TICK and TRIN are your second greatest indicators

3.The index in which the stock you are trading is third most important (and you will want to find an index which has high volume and has a high correlation with the futures,,things llike XLF,XLE,SMH, are good choices for their volume, obviously SMH is better if your watching NQ, and XLF or XLE would be better for ES/YM)

4.In the index you are watching, there may be sub-sectors,,and in these sub sectors you may find stocks even more correlated. For example you may like the financial sector; XLF. If you choose this sector, analyze to see which stocks are most correlated, and which stock often acts as a leader in the moves and which is slow and catches up.
To see what I mean look at this:



5.Now that you have your basket of stocks that you watch everyday, you will watch to see which stock makes the first move in a particular direction, and then you will decide what stock from your basket is most likely to catch up. You do not short the leading stock, that would be stupid, because it will continue in its direction and it's advancement may grow stronger as the sector grows stronger from all of the other stocks catching up. Obviously, your sector is most likely going to move becuase of what the futures are doing.

6.To be good at stocks, it really helps to know how futures trade and how to trade using the TICKS. When trading with the TICK, you look for a higher high or lower low then the previous TICK, and also you need to take note of apparent trend lines on the TICK chart, which when broken, will cause a reaction in the futures, which causes a reaction in your sector and a reaction in its underlying stocks.

I probably watch 15-20 charts during the day. I personally use 1min charts(sometimes 12 sec charts) for trading and when I see a trade setup I just turn my eyes to the bid/ask spread and look for the best entry, I trade the YM and a basket of stocks at the same time, first taking an entry on the YM and then getting into stocks. If I was correct on the YM trade, then my trade on the stocks will pay off too. Most of my trades are in the black within 20 seconds, however, sometimes the ticks may give a fake out and I may have to add to the position before the ticks break the trend line and start moving my trade into the correct direction. I look for an exit on the YM at tick extremes most of the time, unless I'm going to hold the position longer. The exit on the stocks will be after the exit on the YM because the stocks are slower to catch up. Also, it is in your best interest to trade in the direction of the moving average. If you miss a reversal, it is very likely that the trend will continue and you can enter on the next bullish/bearish candlestick harami. However, the point to this style of trading is to notice the reversal in a leading stock, and get into the slow stock before it is bid up or down. While the leading stock may start rolling over along with the ticks and YM, my lagging stock may be at its high, which is perfect for a short entry.

So, when your trading, I would suggest you use a futures contract, the tick, trin, a sector, and a basket of highly correlated stocks. With my strategy, you trade only one direction, which is the direction of the futures, and there is no short the leader and buy the laggard like how Pair trading is based. The ORIGINAL pair strategy works best between different sectors, not between two stocks in the same sector. Also the pair strategy works best on a much larger time frame then intraday if you were to actually try to trade a real "market neutral trade", for example:

This is a classic example of what a pair trade should look like between anti-correlated sectors, you would want to be using options that have many months of time decay so less capital is tied up.

6 comments:

keith on 6:20 AM said...

Hi,

Thank you for this pairs trading blog post. It is great. We are doing pairs trading. Currently, trading 2 pairs, QQQQ vs ORCL and SJM vs KFT since last week.

For other pairs we working on, please visit our website.

Cheers and Happy Trading!!!

eminifuturesblog on 1:18 AM said...

Great post thanks for sharing, when you're trading pairs are you trading the cash, stock or a derivative of it like options or STF?
Cheers
Tim

HPT on 9:43 PM said...

stock.

PS I like your website.

eminifuturesblog on 12:17 AM said...

My many thanks for checking out the website... It's always encouraging to know people are actually reading or at least checking out what you're doing!
Tim

eminifuturesblog on 10:40 AM said...

Thanks for stopping by the blog - I've got another post on there if you're interested... Anyway is there any reason why you just focus on stock? In the UK we have whats called CFDs I don't know if you're familiar with it.. Essentially it's leveraged stock trading and is most effective when trading pairs. I'm primarily a futures trader but am looking at other types of markets, pairs and futures spreads could be one of them.
Keep in touch
Tim

Jared on 9:57 PM said...

That's an interesting pair trading strategy. One pair I'm using in my pair trading system is the euro futures versus oil futures. Since the eurozone imports most of its oil and the ECB consider it a major factor in its inflation models, it tends to generate a persistent correlation between the euro and oil.

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