of our worksheettabs and insert a new spreadsheet.Step 2. Label cell A1 Differential Data, A3 Date, B2 and B3 90-Day MA Differential, C2 and C3 160-Day MA Differential, and D2 and D3 250-Day MADifferential.Step 3. In cell A4, type ⫽‘Stock1’!A2 to import the date. Copy and pastecell A4 through the bottom of the cells that contain data.Step 4. In cell B4, put in the formula ⫽(‘Pair Data’!B5-(SUM(‘PairData’!B5:B95)/90))/STDEVA(‘Pair Data’!B5:B95). (EN 16.2) In cell C4,type in: ⫽(‘Pair Data’!B5-(SUM(‘Pair Data’!B5:B165)/160))/STDEVA(‘Pair
FIGURE 16.3 Chart of 90-, 160-, and 250-Day Normalized Standard Deviations
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Data’! B5:B165). In cell D4, add: ⫽(‘Pair Data’!B5-(SUM(‘PairData’!B5:B255)/ 250))/STDEVA(‘Pair Data’!B5:B255).Step 5. Chart the data from column B, C and D beginning in column E.The resulting chart (like the one in Figure 16.3) has variables that hoverboth above and below zero. Different pairs can produce diverse numbers,though in general the histogram should usually be fairly insightful as to apair’s range. If you have trouble setting up the data, please refer to any of thespreadsheets in the back of the book.Now, returning to our empirical rule, we remember that:• 68 percent of the data will rest within ⫹/⫺ one standard deviation of themean.• 95 percent of the data will lie within ⫹/⫺ two standard deviations of themean.• 99.7 percent of the data will sit within ⫹/⫺ three standard deviations ofthe mean.Ideally, we would like to see all three of our normalized differentialstrade above 2.0 standard deviations before selling a pair and converselybelow 2.0 standard deviations before buying the pair. Going back to our density curve data from Chapter 14, we can now find new information that mayhave helped us make more informed decisions.Generally, the rules for taking a trade are:• The differential (or ratio) must be within 10 percent of the third standarddeviations (in real data) when the pair is instituted.• The differential chart visually displays that the pair is trading away fromthe mean.• The density curve must be printing within 0.003 of the high and low values for the pair. Keep in mind that to substantially minimize risk youcould scale your entry signals back to 0.000 or 1.000 on more volatilestocks, like tech stocks.• The 90-day, 160-day, and 250-day normalized standard deviations (NSDs)must all be above ⫹2 or below ⫺2.If any one of the above indicators is not within the parameters that wehave mentioned, we will usually not take the trade, meaning that we will notpurchase or sell short either stock.
CHAPTER 17
MoneyManagementWhy Money Management?Psychology of MoneyManagementUnderstanding How Pairs CanBe Dangerous
WHY MONEY MANAGEMENT?This chapter may be a little premature; however, at this point I would like toslow down and take a moment to understand the risks involved with tradingpairs, while discussing how to protect ourselves with money management.Even though pairs trading is essentially a hedge, the strategy involves morerisk than directional trading, as each trade consists of two positions insteadof one. Thus, if a position goes against us, we have double the exposure of anormal directional trade, not to mention we are paying twofold more commissions than a regular trade. If we are successively wrong on several positions, our transaction costs can further erode our account. What’s more, ifwe do not have a firm understanding of both technical and fundamentalanalysis, we can endlessly watch our trading capital go down the drain whileour pair creates a statistical anomaly.
PSYCHOLOGY OF MONEY MANAGEMENTOne of the most incredible traders I have ever met has a great way ofapproaching money management psychology. Kevin Cuddie says, “If you donot honor your stops you are lying to yourself and stealing from your family.” While this is extremely harsh, it is exactly true at the heart of the issue.By not honoring our stops we are lying to ourselves from the moment weenter a trade. It is our duty as individual traders and investors to strictly101
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adhere to the trading plan and rules we have already set forth—before weever enter a single trade.When Mr. Cuddie says you are stealing from your family, he is also righton the money. This sentence is very hard to swallow, but if you take amoment to consider the reality of the situation, you may find yourself having an incredible epiphany. Think about it for a moment. When you areinvesting, whether it be directional or pairs trading, you are working withyour (or your firm’s) hard-earned money. As students of the market, wealready have many things against us, including order flow, news, insiderknowledge, earnings, and, of course, our own emotions. It is necessary tounderstand that if you trade, you will lose from time to time, perhaps evenall the time if you are not careful. Simply put, being able to cut your lossesshort is the name of the game. If you do not cut your losses when your stoploss points are triggered, you are taking your own money out of your ownpocket. And if you have a family to take care of, you are taking money awayfrom your family’s livelihood, simply because you could not cut your ownlosses. It is generally true that we all want to progress both emotionallyand financially forward; accordingly, if we waste our resources on losingpositions, we hinder our ability to advance.If you have a $100 account and you let a loss in one trade wipe out halfof your account, you are in big, big trouble. Why? To recoup your originalprincipal of $100, you now have to make 100 percent in the next trade to offset your original 50 percent loss. How many trades have you ever made thatearned 100 percent? If you are like me, probably not many. Thus, we striveto take small loss after small loss, to then yield a large winner. Moreover,when we do not accommodate stops and take large losses, we only breedfear. And when you trade with fear, you might as well not be trading at all.When you fear losing money, you will find yourself with analysis paralysisand not be able to pull the trigger to enter a trade, or fear losing the rest ofyour money and not be able to close a losing trade.The game blackjack has some interesting principles of money management that we should strive to learn from. First and foremost, when you placea bet on a blackjack table, you have specified your exact money management plan (in advance) for that particular trade. Unless you double down orsplit cards somewhere in the middle of the hand, you have specifically statedhow much you are willing to risk. When the hand is over, if you have lost tothe dealer, your money is taken by the house. At that point, you may be veryhappy that you didn’t bet more! Unfortunately, when an equity trade goesagainst us, we do not have the luxury of a set loss unless we are dealing inoptions or some other financial instruments. If we continue to play the hand,
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our losses can go on inevitably, or at least until we are completely broke.What’s worse is that if you are trading on margin, you can lose even moremoney than your account has, and actually end up owing money—clearly nota predicament that any us of want to be in!Once our losing blackjack trade is over, it is then our responsibility tostop trading. As individuals, we must be accountable for our own decisions.No system in the entire world is completely foolproof; therefore, it is crucialthat we understand losses will occur. Much like the blackjack table, we muststop trading when we are down and review what went wrong. Further, if wedo not have expendable capital to step back up to the table with, then weshould just walk away. Trading, much like gambling, is not for everyone.More importantly, pairs trading may also not be for all individuals, especiallyanyone who does not have the time to conduct the proper research andanalysis. The information in this book is only as effective as the investor whoindividually pulls the trigger to enter a trade. Again, the statistics in this bookwill be wrong from time to time, consequently leaving us (as individuals) toknow when to stop the bleeding.
UNDERSTANDING HOW PAIRS CAN BE DANGEROUSWhile we have already gone over both technical and fundamental analysis toassist our pairs knowledge, the crux of this book is based on statistics. As Ihave already mentioned, our statistics can fail us from time to time. How?First, there is always the risk of human error. What if you build a spreadsheetand have the formula in just one key cell wrong? The result could be detrimental to your account if the mistake is not caught before a trade is entered.Second, pairs are only as strong as the statistics that back them. In all statistics, there is always the risk of an anomaly that skews the data. Thus, ifour pair is at an outlying point where we receive a buy or sell signal, thetrade is definitely not a sure thing. Despite the hedge, we must understandthat the pair has diverged for a reason. It is our job as pairs traders to figureout why and then attempt to understand whether the correlation is strongenough to draw the two stocks back together. Take, for example, the buy signal for KLAC/NVLS that we received on October 3, 2002. In an independentevent that affected our pair, Advanced Micro Devices (NYSE: AMD) hadwarned on October 2, 2002, while the broader chip sector seemed to be rapidly falling to the wayside. Then on October 8th, when we took our position,Lehman Brothers analyst Edward White announced that the semiconductorsector could see weaker order trends throughout 2003. However, Mr. White
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stated that he expected a few stocks to hold up well, specifically mentioning KLA-Tencor, the buy-side stock in our pair. While this news event helpedto drive our pair in the right direction, consider the other side of the coin.It is very possible that White could have upgraded Novellus instead of KLATencor. If such had happened, our pair could have quickly slipped furtherinto the bowels of the investing earth, while we sat by in a losing trade.Also, during early October 2002 we were in the middle of warnings season,when many chip companies were announcing that they would miss theirnumbers. The event risk that we faced was that KLA-Tencor, could haveannounced either tragic earnings numbers or guided lower for the comingquarters. Either incident would have caused us to lose money in our trade.The point here is that statistics got us in the trade, while positive currentevents helped us get out with a winner. If you are not shaking your head atthis very moment saying “I will never trade pairs, ever,” then I am not surewhat more I can say to convince you of the danger you face by trading statistical arbitrage.My intent during this chapter is purely to talk you out of pairs, for if youare nervous after the last few sentences, perhaps pairs are not for you. If thisis the case, please believe me when I say “no big deal.” As traders, we findourselves adapting to investment styles that fit our personalities much likedifferent artists use different painting techniques. If you are a marketimpressionist, please do not try to fit in the box of surrealists. Your style isyour style, and for many, the risks associated with pairs simply do not fit intheir money management plan or psychological profile.
CHAPTER 18
MoneyManagement IIFundamental PrinciplesKnow YourselfThe Plan
FUNDAMENTAL PRINCIPLESThe fundamental principles behind money management are very simple.However, as people with emotions driven by fear and greed, we can have anincredibly hard time sticking to our strategy. The foremost principle is don’tlose money—ever. While this many seem a little elementary, it is a muchharder task to implement than we perceive. Have you ever let a trade goagainst you thinking it will come back? Were you a part of the bull marketbubble that blew up in all of our faces?Let me tell you a little story about one of my more fantastic moments.While in college, I had the opportunity to participate in a pre–initial publicoffering, about which I knew almost nothing. However, it seemed like a fantastic deal at the time, so I put my hard-earned money to work. The companywas/is called Homeseekers.com. At the time it was named something else, butthe actual name no longer matters. I invested $10,000 in roughly 5,000 shares ofthis wonderful company at $2 a share. What a deal for a dot.com. I sat on thestock all through school, waiting for something to happen. Then after I wasfinished with my degree, the stock went public and I had the opportunity toexercise an additional 5,000 shares at $3. At the time it seemed like anotherwonderful opportunity, as the stock was trading at roughly $4. I scraped up themoney and put my capital to work. I now had 10,000 shares in my account.Going into December 1999, the stock fired up to $15 a share, where I took someprofits out. I think I cashed out about $70,000 worth and decided to let the restride. I was sure I would be a millionaire before I was 30. Then, just after January2000, the stock began rapidly descending. I kept telling myself, just a pullback,105
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just a pullback, just a pullback, which it wasn’t. I never sold the remaining position of my shares, and at last glance the stock was trading on the NASDAQbulletin board at 0.001 cents a share. If I just cashed out all of my position nearthe top, I would have made over $250,000. But I didn’t; I rode it into the ground,just like any self-worthy Wall Street cowboy should. The bottom line: I had noplan and gave up a lot of money because of it.If we are going to understand money management, we have to have aplan—any plan, just have a plan.
KNOW YOURSELFTo have a money management plan, you must first take a moment and get toknow yourself. Ask yourself: Am I driven by a trading goal? Am I driven by thesuccess of the trade or by the fear of losing money? Either way, are you drivenby fear or greed? If you are driven by greed, then you must make sure you havean excellent money management plan with tight stops. However, if you aredriven by fear, then you may want to loosen your stops a little, to ensure thatwhen you do have a winning trade, you can hang on to it for a larger winner.No matter which end of the spectrum you are on, it’s important to understandthat all negative actions lead not to greed but, rather, fear. And fear is the ultimate trading destroyer. There is a fine line between being a responsible moneymanager and trading with fear. If you trade with fear, you close every trade thatgoes against you, if even by a few pennies. This is good, as you will never loselarge amounts of money; however, you will never be able to make any realmoney or make rational, unbiased decisions. The best money managers in theworld understand that there is a middle ground, where trades are closed whenthey violate preset technical, fundamental, or statistical levels. Thus, the shortcut to becoming a great money manager is to simply have predetermined stopsbefore you ever take the position. Then, you have removed yourself from thetrade and are unbiased about the trading action that follows your entry. Andthis is how to get to know yourself. If you rationalize your stops before you takethe position, you can record your emotion when your stop nears. Do you wantto leave the trade open to make more money, or close it out of the fear of losing?
THE PLANFirst and foremost, you should never, ever, ever take more than an 81⁄2 percentloss on each side of your pairs trade. The total capital lost equals 17 percent and can still be devastating to an account. When you calculate an
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entry, one of your stops should always be 81⁄2 percent per side. And ifeither side hits, close the position. The fundamental idea here is to neverlet a trade go against you endlessly. For more conservative traders, youmay want to actually lower the loss percentage to 21⁄2 to 5 percent, thusprotecting yourself from unnecessary losses. The fundamental crux hereis that the lower your loss risk percentage, the better timed your entrymust be. If you only want to risk 21⁄2 percent, then the wisest decision maybe to bump your density curve entry up to 0.000 or 1.00. Of course, thismeans that you will hardly ever get into a trade, but it also means that youwill risk much less in terms of the statistical entry. What’s more, for moreconservative traders of 21⁄2 percent, you may want to also move yourstandard deviation entry up either near or above three standard deviations.The bottom line: The more conservative you wish to be, the pickier youmust be.Second, it is vitally important to have technical stops as well. Reviewyour charts and find points where either stock is staging a technical breakout or breakdown that will cause one half of the position to fly out of whack.If that point is breached, close the trade. Figure 18.1 gives a good example.Using a simple trend line, we can see that Dell Computer was headed downduring the first part of 2003. The chart also displays a clearly marked trendline that you could have used as a short stop for either pairs or directional
FIGURE 18.1 Dell Technical Stop
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traders. Once the stock closed above the descending resistance line, it wasoff to the races. It is vitally important to have technical stops on your chartas well as capital percentage loss stops in your account.Third, statistical stops should also be set hard and fast for any trade. Igenerally use the third standard deviation as a good point to close positions,should the trade go against me. However, if I am taking a position on the second standard deviation, the third standard deviation can be quite a waysaway, and can infer substantial losses if the losing trade is held that long.Thus, I use the third standard deviation as an actual stop only when I implement a trade within 10 percent of the same standard deviation. Moreconservative traders may want to decrease this number significantly, thoughremember that to do so also means you must time your entry properly inorder to avoid being quickly stopped out.
CHAPTER 19
The Realityof PairsDo Pairs Really Work?Trader or Investor?Making the Style Work for YouIntraday Pairs
DO PAIRS REALLY WORK?The answer to this question is as rhetorical as the question itself. Pairstrading is not a system that will automatically fill your account with endlessamounts of easy money. In fact, pairs trading might actually be more difficultthan regular trading. Think about it. If you are a directional trader investingin only one stock, then your research is fairly limited. You only do fundamental research on the stock, sector, and market. Then, look at the stock’stechnical indicators, while also taking notice of historical news and pendingevents. After this is completed, you may then have a good idea whether thestock is worth trading. However, if you are a pairs trader, you have to conduct the same amount of research on two stocks instead of one. You cannow see that this is not for the faint at heart.Pairs do work; however, trading pairs is only as effective as the investorexecuting the trades. If you are willing to do only half of the research, thenyou will likely lose half (if not all) of your money. If you put in 100 percent,you will likely break even. The only way to make your account grow is to putin more effort than your competitor—and in the market, you are competingagainst everyone else. This may sound discouraging, but it is a market truththat will not go away. We cannot deny our responsibilities of hard work andexpect to get lucky. Thus, if we really want to trade our own money and besuccessful, we have to put in 150-plus percent.If used correctly, pairs can hedge your risk in times of uncertainty. Youmay be tempted to trade pairs with sexy, high-flying stocks. However, ifyou instead stick to slower-moving, more fundamentally sound companies,109
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you may very likely have greater results. Take energy stocks, for example.Some of the larger energy companies have moved incredibly slowly overthe past decade, while paying out consistent dividends. These stocks rarelyhave any volatility of divergence, unless some sort of scandalizing event orcrisis occurs. Many institutional investors have valued these stocks to thepenny and know exactly what each is worth. Thus, as long as the event thattriggered divergence is not caused by an event that is incredibly scandalous, the two stocks will likely return to their original value, which areexactly the opportunities that you and I, the pairs traders, are looking for.Do pairs ever fail? I can only answer this question with a resounding“heck yes!” During 2000 to 2001 I traded an account that had a 100 percentwin/loss ratio. This means that we had no losers. Let me rephrase that to bemore correct: We had many pairs trades that had both a winning side and alosing side. However, the winners always exceeded the losers; thus, theoverall pairs positions were winners.Then, going into the first few weeks of September 2001, we found awonderful position, with two large companies that appeared to present lessrisk than other flamboyant high-flying stocks. The two companies wereBoeing and Lockheed Martin. To be exact, the two companies were tradingapart two and a half standard deviations. As a result, we bought Boeing andsold short Lockheed Martin. The trade looked amazing, and we anticipatedthat the position would yield at least 10 points.Then, on the morning of September 11, 2001, I left for work slightly laterthan usual. I needed to give my wonderful better half a ride to work. Afterdropping her off at her office building, I pulled into traffic and heard what Ithought at the time was a joke: “A plane has hit the World Trade Center inNew York.” I switched the station once, twice, three times—and then I knewit was for real. What I also then realized caused me to pull over for a momentand take a deep breath. I formed a hypothesis in my mind and drove to theoffice. When I arrived on the trading floor, all of the traders were not at theirdesks, but rather, were standing in front of the TVs watching CNBC andCNN. I knew what was going to happen and prayed for the market to openfor just one minute—all I needed was one stinking minute to get out of ourpositions. Then, when the New York Stock Exchange did not open and thesecond plane hit, I knew our fate was sealed. I left work that morning andwent home for what would turn into a week off while the markets stayedclosed. As the week progressed, I listened to the news and realized more andmore each day that the account that I put the Boeing/Lockheed Martin tradein was now on fire also. It was kind of like standing in front of a firing squadfor days on end; waiting for the inevitable, and then waiting some more.
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The problem was obvious: Though Boeing had a substantial amount ofbusiness from defense, it also heavily relied on selling jets to commercialairlines. And when a terrorist attack comes in the form of commercial airlinesturning into hellish missiles over your own country’s soil, people stop flying.When people stop flying, the airlines stop ordering jets. And when the airlinescease purchasing or discontinue current leases, the companies that manufacture planes (Boeing) take a huge dive. Conversely, Lockheed wascompletely exposed to defense; thus, the attack was sure to bring aboutimmediate defense budget increases. And it did. Shortly after, the defensebudget packed full of cash for research, development, and production for military/defense weapons and technology was passed. Washington soon afterpassed a fiscal stimulus package that amounted to $75 billion, of which manydefense companies like Lockheed Martin received a good portion. The futurewas imminent, when the market opened again, I was sure Boeing would gapdown and Lockheed Martin would gap up. And that’s exactly what happened.When the market reopened on Monday, September 17, 2001, the Boeing/Lockheed Martin pair gapped against us 14 points. Everything we hadmade for the entire year (and then some) went up in smoke. The accountwas devastated.I had never expected this situation to occur and had no idea whether thecorrelation would hold. In short, I had no idea if the trade would come back,but knew that the account could not stand to lose one cent more. Theaccount had grown 33 percent for the year prior to September 11. When themarket then opened on September 17, the losses totaled almost 45 percentof the September 10 close. Just to get the account back to where we hadstarted for the year, I needed to make 37 percent, and to get back to the levelwhere the account closed on September 10, we needed to book 82 percent.I’m not sure which was more devastated—the account or me.This is where I learned the most important lesson of my entire tradingcareer. When you are down and out and are thinking about batting for thefences to recover losses, stop trading and take a break. Write down exactlywhat went wrong, or at least what you think went wrong, and put that pieceof paper away for a while.The irony of the situation is that the pair did come back, and if I had justleft the trade open, it would have returned to its original value. However,even though I took a huge loss, I did the right thing. The situation was ananomaly and presented more future risk than it did reward. Had I not beenin Boeing/Lockheed Martin before September 11, it would have been a greatopportunity to take a position on the 17th. But then again, my 20/20hindsight account never loses a trade.
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What I did after September 11 was keep trading. And from there Imanaged to give up another 6 percent in the following six months. At thatpoint I took a break, and thank God I did.I decided to take some time off from trading during the late spring andsummer of 2002. In fact, I don’t think I actually placed a single trade untilSeptember 2002! During that time, I left the trading firm I had been at to gowrite for a financial newsletter. My timing when I stopped trading was oneof the most lucky events of my entire life, as another market anomaly wasabout to take place, and at the time I did not see it coming—nor would I haveknown how to deal with the situation that would be presented.During the summer of 2002, the market completely fell apart when theDow Jones Industrial Average, NASDAQ, and Standard & Poor’s (S&P) 500all made fresh bear market lows. If there was one prominent theme to themarket that summer, it was scandal. Companies like Enron, Citigroup, andTyco were littered with corruption and accounting scandals. And investorsquickly learned that if you can’t trust a company’s officers and accountants,just get the heck out. The resulting action triggered mass selling in a varietyof different companies, and the selling generally appeared overnight. If atthat time you were trading pairs based on statistics and/or correlations, thenyou most likely got killed. Thankfully by pure chance, I was not. And, whenI went back and began reviewing trades that I might have taken, I was verypleased about my decision to take a break. September 11 and the summer of2002 taught me two very important things.First, statistical arbitrage is only as good as the legitimacy of the correlation supporting the trade. I am mostly speaking of convergence tradinghere, though this also stands true for divergence trading as well. Basically,when the events that pull companies apart are so extreme that companiesare filing for bankruptcy, corporate insiders are being made to do the “perpwalk,” or class action suits are beginning to rise—just stay out. Of course,some argue that the aforementioned events create a perfect situation fordivergence trading. However, I have yet to meet anyone who can accuratelypredict such events on a consistent basis and make money. When in doubt,stay out.The second lesson is that when the market begins to capitulate or is atan extreme level, that is, the Market Volatility Index (EN 19.1) is above 40, itmay be a good idea to sit on the sidelines. After all, if we are divergence trading, then we want to wait for the rubber band to completely expand, versustrying to time the trade before the pair has capitulated. Of course, we won’talways be correct, but, when significant moments of substantial uncertaintyarise, it may be in our best interest to pass for a more reliable opportunity.
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After all this, what I am trying to say is that pairs do work; however, muchlike any other trading style, there will be times when the bottom falls out.From here, we will soon see that money management is the name of thegame.
TRADER OR INVESTOR?This is a question we must all ask ourselves. My advice in answering thisquestion is to simply ask yourself how much time you have every day towatch the market. If you are not in a position to watch the intraday movements, you are an investor, not a trader. This is not a bad thing at all actually!In fact, this is absolutely outstanding, as most intraday traders (day traders)take on the most risk. I know, because I’ve been there. The problem withtrading pairs on an intraday basis is that if two stocks are separating, they’redoing it for a reason, and could very likely close at a high. This means youlose. Though we only briefly went over intraday pairs, I would not recommend day trading for the average Joe. Being an investor and trading withlonger-term data, you have the ability to analyze your data and are notfighting against intraday order flow that you have no idea about.To be an investor or, should we say, “swing trader,” is most likely thebetter bet. When we hold a position for a shorter amount of time, as in twodays to two months, we are keeping our capital at work, while not exposingourselves to long-term risk.There is a concept known as churning, which is also branded asovertrading. A broker who is trying to make money on commissions typicallydoes this; however, swing traders who move in and out of their positionsexcessively can also be guilty of churning their own account. As pairs traders,we must be careful not to overtrade, as each pair has a long and short position, and thus, double the commissions. This is another reason I do notrecommend intraday pairs trading, as the commissions can be horrendous.
MAKING THE STYLE WORK FOR YOUTo make the style work for you, you must stay abreast of your data. Youmust update your data daily and watch for opportunities. What’s more, to bean effective pairs trader, we must also watch the news events surroundingus. If we are trading pairs into earnings season, and the companies that tradewith our pair begin warning, it is a good idea to examine the possibleoutcomes for our stocks. Despite correlations, our pair can make dramatic
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swings during times of tribulation, like earnings. The last thing we want todo is wake up to a poor earnings report for the stock that we are long in.Even if the correlation is strong, the stock we are short may not react thesame as the stock we are long. In this scenario, I highly recommend lookingthrough each company’s earnings estimates and searching for analystguidance for the pending announcement. If our long stock has recently lowered earnings guidance and our short stock has not, it may be a good idea toexit the position as a precautionary measure to potential losses. After all,missed money is much better than lost money.Please also keep in mind that each investor’s risk tolerance is