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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. |
