Rob Friesen - Opening Strategies
OPENING STRATEGIES WITH PAIRS - by Rob Friesen
If we take the last price of Centex (NYSE: CTX) and subtract the last price of Lennar (NYSE: LEN), two correlated homebuilders, we will get a current spread price or differential of -3.50. I will refer to this spread as CTX-LEN. If we plot that spread price we will be able to see a long-term range and also an average daily trading range.
First for some definitions of the volatility indicator we are using. True Range is the greatest difference of the following:
1. Today's high and today's low.
2. Today's high and yesterday's close.
3. Today's low and yesterday's close.
Average True Range (ATR) is calculated as the moving average of true price ranges over a given period. It was developed by Welles Wilder.
Currently, CTX-LEN has an ATR of .99 over 5 days and 1.09 over 65 days. I like to compare the short-term ATR with the longer-term looking for consistency or anomaly. Dramatic differences alert traders to changes in the stability of the pair or of news engines causing divergence. I also monitor the ATR over time and adjust my trading to rising or declining measurements. The longer the pair trades with a very tight ATR, the higher the probability of an expanded range day or a period of extended moves. The current correlation between the two stocks is: .8921
Now on opens...If the pair immediately post open (once both stocks are open) has moved up or down 35% of its ATR using the previous day's spread price close, I go after it by fading the move. So if the spread opens up .34 or more, I short CTX and buy LEN...and if it opens down .34 or more I buy CTX and short LEN. Sometimes the Short can be difficult to get, so the edge will come in whether you had a position overnight. It is also necessary to observe which is the hard side of the pair and perform that trade first. Most commonly we get partial retracements, occasionally full retracements and occasionally the pair continues in the direction of the gap.
Sometimes through the indications shown on the individual stocks pre-open, a spread price can be determined for what may happen on the open. I always try and have OPG orders (Opening Only Orders) in the market looking for stocks in a sector that open at a premium or discount to the group and will "pair off" some of these opening anomalies. Otherwise on CTX-LEN, having an OPG order can assist me in participating in that Opening Print, which may be the best price of the day.
When posturing orders to "achieve a good spread price" right off the opening, there may be some poker bluffing on indications by NYSE Specialists in addition to the stocks opening at different times. This all adds to the risk of getting caught with a losing trade or a poor spread price. My recommendation is that a trader new to pairs, focus on the post open event first and progress into strategic placement of OPG's to achieve great spread prices.
The real key to maximizing safety and increasing your profits is to work with the fundamentals and the technicals. In other words, there is a time that if the spread opens down that 35% and is near a support level, as well as the fundamentals supported my actions in buying CTX and shorting LEN; I would have a compounded edge. I would be "lining up the ducks" for the pair trade. I may only fade half a regular position at the open if I am against the fundamentals and then it is meant for an opportunistic trade and should not be added to if it goes bad. If I were already long I would take some profit, maybe through taking a leg off or half my position, wait for a pullback and re-establish the position or leg. We have the opportunity on a regular basis to add or subtract capital to our pairs and if the size is kept reasonable respective to our trading account, we can enjoy steady profits from this strategy.
If you are doing opening only orders in general, having a hedge or pair stock for every stock you place OPG's on can give you an extra measure of safety and increase opportunity. Sometimes an opening trade can go bad, and it is comforting to have other options like pairing it off and trading it from a market neutral stance. Through earnings seasons, stocks open and may continue in the direction of the move so additional allowance is made for this.
Of course there are many variables that I address in a mentoring environment but this can give you a start on what to look for.