to enter the position. Figure 22.6 shows the density curve data overthe last month.
Wednesday, October 1Now I am getting really excited, as the pair has continued to open up, withthe differential currently at 28.29 and the ratio at 1.68. The electrifying parthere is that both the differential and the ratio are very close to the thirdstandard deviation, which means that (if we ever take a position) we will betrading with nearly 99.7 percent of the pair’s data. Generally, I like to findpairs with differentials and ratios trading as close to the third standarddeviation as possible, without going over. The problem is that once thethird standard deviation is violated, the remaining 0.3 percent of data cantranslate into infinite pain for our pair. Thus, I generally always use thethird standard deviation as a secondary tier stop loss. Call it a reserveparachute, if you like. If I take a position close to the third standard deviation and it is subsequently violated, I then close the entire position,regardless of other stop loss parameters. Close the losing play, live totrade another day.Addressing concerns that we have for the pair—even though we don’thave a position yet—Anadarko was hammered lower in the last few days ofSeptember. I imagine that part of this was due to September being the lastmonth of the third quarter, and many funds, institutions, and personalmoney managers did not want the stock to show up on their quarterlyreports. Thus, they dumped Anadarko, as is did not perform very well in thethird quarter. Coincidentally, the stock found support on the last day of themonth and actually closed positive today. The buoying action of the stockinsinuates that some investors who recently sold positions are now reclaiming them at a lower price for the fourth quarter. And, of course, some of thegains over the last two days can be attributed to short covering as well.
Trading Diary
149
FIGURE 22.6 APA-APC 9/30/03 Density Curve Data
The most important concern I have now is that the stock is trading justover $41, and only slightly above my stop at $40. As mentioned before, I willclose the position if the stock violates the $40 whole number. The problemis that the stock is trading near our stop before the trade has actually beenentered. Thus, if $40 is sullied and we still have not received an entry signal,
150
TRADING PAIRS
FIGURE 22.7 APC CHART 10/1
I will toss the trade in the dumpster anyway. The point here is that tradingonly with pure statistics rules out common sense. And discarding this tradeif Anadarko falls below $40 is common sense.Figure 22.7 displays Anadarko’s trading action over the last few days. Italso shows the descending resistance line that we would like to see thestock eventually ascend back over in order to indicate another leg of tradingwithin the $40 to $50 range.
Thursday, October 2And here we go! Are you nervous? I am. The pair finally received the buysignal today, so now it’s time for me to put my money where my mouth is.This entire book comes down to today, the session that provided an entrysignal for an actual pairs trade. What’s more, this is the first time theApache/Anadarko density curve has hit 0.997 in the history (over six years)of data we are covering. The closing differential today was 28.75, while theratio was 1.69; both still above two standard deviations. Figure 22.8 showsour Pair Data sheet and the actual sell signal.Incidentally, the signal was derived from Apache’s move above $70,which was a new 52-week high. And so I am asking myself, “Why would Iever step in front of a stock trading at a new 52-week high—am I insane?”And while the answer may partially be yes, I know that I have done myresearch. Apache looks top heavy, and, statistically, the pair looks as if it
Trading Diary
151
FIGURE 22.8 PAIR DATA 10/2
is nearing maximum divergence. To tell you the truth, I generally preferpairs in which both stocks are range bound, and neither are making a new52-week high or low. Figure 22.9 shows just how strong Apache is.The actual plan for the trade is this: Tomorrow morning, I will buy 1,000shares of Anadarko after 10:00 A.M. EST and sell short 1,000 shares of Apacheat the same time. The reason I am choosing after 10:00 A.M. EST is that I liketo let some of the morning’s order flow—and trading action—shake outbefore I put my money in. Usually, I actually look at the stocks in the morning and then make a decision to enter on the open or wait. However, for the
152
TRADING PAIRS
FIGURE 22.9 APA 10/2 New 52-Week High
sake of the book, I will wait until after 10:00 A.M. EST before taking my positions. Also, keep in mind that we are taking our position ahead of earnings.When I can avoid it, I usually try to not trade ahead of earnings announcements. However, in the case of Anadarko/Apache, as we already discussed,the upcoming earnings could actually help the pair reverse in our favor.
Friday, October 3This morning I entered my position at the following prices (rounded to thenearest whole number):• Anadarko Petroleum: Long 1,000 shares @ $41.60 ⫽ $41,600 in capitalexposure.• Apache Oil: Short 1,000 shares @ $70.50 ⫽ $70,500 in capital exposure.Thus, I am risking $112,100 on this trade.My stop parameters for the position are: First, if the position moves abovethree standard deviations, I will close the trade. The differential of my positionis 28.90, and the differential of the third standard deviation is 31.41. Thus, if Iam stopped out by this method, I stand to lose $5,020: [($31.41 ⫺ 28.90)*2,000]⫽ $5,020. This would equate to a 4.5 percent loss of my trading capital.
Trading Diary
153
FIGURE 22.10 Trade Summary 10/3
Second, if Anadarko falls below $40, I will close the position. It is hardto figure exactly how much I will lose, but I can assume that it will be $1,600from my entry on Anadarko, plus or minus any gain/loss from Apache.Third, if we were not trading near the third standard deviation, I wouldnot risk more than 8 percent of capital on each side of the trade. However,this is the most risky way of pairs trading, as it can wipe out 16 percent ofyour account. This is only to be used by investors who can afford to lose allof their trading capital. If you cannot afford to lose, do not trade. It’s thatimportant!This trade has an unusually low risk-to-reward ratio for a pairs trade, asnormally when we are risking 16 percent of our capital, we stand to barelymake that much if the trade works out. Thus, what I do is put tight trailingstop losses on my positions once they begin to work in my favor. Also,another tactic I often use is to quickly close part of the position once itshows gains. That way, I make sure the commissions (which are double) arepaid for, while trying to put a little dough in my pocket.Figure 22.10 is a breakdown of where our trade stands. As you can see,we are already $840 out of the money including commissions. Ouch! Theclosing differential closed above our entry, which is not good for our pocketbook or peace of mind.
Monday, October 6Our first reaction to today’s trading is “oh no,” as the pair has continued toopen up against us. The differential is $29.79, and the density curve is stillat 0.997. What’s scary here is that the density curve could continue to openup to 1, where I would be stopped out at for a large whopper of a loss. Andlosing money is no fun. However, considering that the trade moved againstus by only 8 cents, I am not worried yet. Also, Anadarko gained ground,which is a positive sign. Remember, we are hoping the stock will rise above
154
TRADING PAIRS
FIGURE 22.11 Trade Summary 10/6
$45 to indicate a breach of descending resistance and a potential move tothe upper end of the annual range. Currently, we are down 0.82 percent inour position, which translates to $920 dollars. What’s more, the ratio isonly 0.02 away from the third standard deviation, which is concerning,even though we are using only the differential as our third standard deviation stop. Figure 22.11 shows our loss to date, including commissions, ofcourse.There was no significant news today.
Tuesday, October 7The trade moved in our direction today, with the differential coming in to 29.61.While I am still out of the money $750, the picture is getting a little brighter.Wachovia Securities upgraded Anadarko to Market Perform (EN 22.1),which is an outstanding sign for our trade. Though the stock did not gain anyground, Wachovia is likely seeking some sort of merger talk to help bolster buying sentiment.Apache continues to gain ground and is picking up momentum. Thestock closed at $72.51—another 52-week high. Thankfully, Anadarko is alsohanging in there, closing at $43.02. While I am concerned that the trade isstill negative, there is no reason to panic yet. Figure 22.12 displays the gainsthat Apache’s stock has made.My feeling is that if the stock wasn’t top heavy before, it is getting therenow. Also, this is the perfect scenario depicting how pairs trading can befrustrating and mind-boggling. I have attempted to short an incredibly strongstock and am paying dearly for it. My feeling is that investors are purchasingthe stock ahead of earnings, which could lead to a “buy the rumor, sell thenews” type of scenario.Figure 22.13 shows the current trade summary.
Trading Diary
155
FIGURE 22.12 APA 10/7 New 52-Week High
FIGURE 22.13 Trade Summary 10/07/03
Wednesday, October 8The density curve has been pegged at 0.997 for the last four days; however,the differential has fallen to 29.42, which certainly bodes well for the trade.I am happy to see the position cool off, but will reserve my emotions untilthe differential falls below the entry point. The trade still has a considerableamount of risk, as any bad news for Anadarko at this point could quicklysend my capital into someone else’s pocket. In addition, the ratio is still at1.69 and has not come in at all. I still maintain that Apache is overbought andthat the current trading action is simply buying ahead of earnings. Mybiggest fear here is that Apache will consolidate for several days, then break
156
TRADING PAIRS
FIGURE 22.14 Anadarko through 10/8
FIGURE 22.15 Trade Summary 10/8
out. Anadarko has been gaining some momentum and is moving away fromthe $40 stop, though until the stock actually breaches the short-termdescending resistance line, I won’t get to overzealous. Figure 22.14 displaysAnadarko’s current range, and shows that the stock is gaining momentum.In news today, Apache announced that it made a second discovery offthe shore of Western Australia. Though this news won’t really affect thestock much, it is positive news indicating that the company is still aggressively finding new wells. If I wasn’t short the stock, I would be very happyabout the find.
Trading Diary
157
As the following trade summary in Figure 22.15 depicts, we are still negative, with the position down $560, or one half a percent, “Apache fall,Apache fall, Apache fall,” I am thinking.
Thursday, October 9Wow! What a difference one day makes—the trade has come positive, andnone too soon! The differential fell below my entry of 27.84. The catalyst forthe decline came from Apache receiving a downgrade by CS First Bostonfrom Buy to Neutral. In my opinion, the firm sees that the company is overvalued and has acted on such information. (Keep in mind that this just myguess.) One area of concern, though, is that the company has confirmed ashareholder meeting on December 18 for a previously announced stocksplit. While this news will not directly affect the price in the near term,stocks have a tendency to run up ahead of splits. Thus, I will be relieved toexit the trade early if the position falls farther in my favor. However, thelower lows created in the past two sessions have somewhat relieved my fearthat the stock could be consolidating for another breakout. From here, thestock will likely fall into the $68 range, otherwise known as near-termascending support. Figure 22.16 shows the density curve, which has fallen to0.995—an excellent sign for our trade.Also encouraging, the ratio has fallen to 1.65, thus backing off from thethird standard deviation at 1.72. Sometimes it takes investors several daysto digest up/downgrades, which could translate to more selling on the horizon. At the end of the day, the good news here is that in the last week, thetrade has had one upgrade for our long position and one downgrade for theshort side. This is a good sign that we are on the right side of the rubberband—the contraction side. The position is now positive $1,020, or 0.91percent. If I were to close the trade here, it wouldn’t be a bad take for onlyfive days of trading. One percent every five days on $100,000 translates to52 percent in gains each year. Not bad, but a completely unreal number.But then again, its okay to dream, isn’t it? (See Figure 22.17.)
Friday, October 10The differential popped back up to 28.69 and has eroded the bulk of thetrade’s profit overnight. But the important thing to remember is that thetrade is still green, and that’s all that matters. The density curve picked up alittle momentum and has risen to 0.996, but isn’t anything to worry about atthis time. My only real concern is that the position collapses before I have to
158
TRADING PAIRS
FIGURE 22.16 APA DENSITY CURVE 10/9
close it in November. I would feel silly to publish a loss, but I will recordwhatever happens, for better or worse.Anadarko’s chart in Figure 22.18 is cheering, as the stock is building abase above $42, which is now support. I hate to think the stock could beforming a bear flag (consolidation after a large downward movement) thatmay indicate another big drop coming up. While I don’t think this is the case,
Trading Diary
159
FIGURE 22.17 Trade Summary 10/9
FIGURE 22.18 APC 10/10 Bear Flag
I must consider all possibilities of my trade, even the not-so-bright ones.Figure 22.18 displays the possible bear flag forming. Usually though, a bearflag forms only after a large vertical drop, which in this case the stock didnot do. The bear flag is normally the first part of a “flag and pennant” pattern,where in a consolidating “flag” is first formed, followed by a substantialdecline and then more consolidation.The trade now has a meager profit of $170 after commissions, whichwould equate to $130 if closed. While it is a little discouraging to see theprofit dwindle, I am very optimistic about the future of the trade. There wasno notable news for either stock today. (See Figure 22.19.)
160
TRADING PAIRS
FIGURE 22.19 Trade Summary 10/10
FIGURE 22.20 Trade Summary 10/13
Monday, October 13Here I am, red again! The differential gained ground over the last day, and isnow at 28.96, just above my entry. Overall, the trade is down $100—nothing toworry about. What I don’t like, though, is that Apache looks like it is consolidating for another leg higher—yes, the thing I was worried about earlier. However, the density curve is still below our entry at 0.996, while the ratio is at 1.67(see Figure 22.20). This is where I generally enlist faith in the statistics and hopethat they will prove true. Incidentally, hope is the last thing you ever want in atrade. Maybe you should put the book down and go get a beer—I know I am.
Tuesday, October 14I’m glad I had beers last night instead of worrying about my trade, and itseems to have paid off. The position is now working in my favor again, withthe differential at 28.52. Given that the differential has been hovering aroundthis area, and that the density curve has not been able to move higher, I havea feeling that the trade will begin to show some profit. The chart for Apacheis still very strong, and I wouldn’t put it past exuberant buyers to push the
Trading Diary
161
FIGURE 22.21 Trade Summary 10/14
stock higher. My question now is: Who is the greater fool? Who is foolishenough to buy the stock here, thinking that someone else is going to buy ithigher? I can see purchasing Anadarko at $46 or $47—higher than where thestock is here—but Apache? No dice. The risk to reward for the stock is getting too high for the average investor to stomach, and in my opinion, thecompany knows it. That’s why we have recently heard talk of a split, to makethe stock cheaper and more attractive for additional investment.At this point our trade is positive by $340, and after taxes, I’m not sure ifthat’s even a car payment, so we’ll press on.There was no notable news on either stock today. (See Figure 22.21.)
Wednesday, October 15We’re back in business. The differential fell to 28.07 and has our profitbuilding once again. Though we haven’t made any real money, the trade isencouraging. There was no significant news on either stock today; thus, theselling was due to the larger movement of the market. I am keeping a closeeye on Anadarko, which has fallen to $41.56. If Anadarko falls beneath $40,the whole trade gets closed—win or loss. My reason for the $40 dollar stopis in the cliché “You don’t have to buy, but you do have to sell.” What thissaying means is that it will be more difficult for Apache to ascend than forAnadarko to crumble. If the stock breaches $40, then many investors willsay they’ve had it with the thing, and throw in the towel. Add in a couple offunds exiting their positions, and we could see an all-out dump in the stockequating to several points evaporated. I for one don’t want to be along forthe ride and, statistics aside, would rather sleep at night than spend my timewishing someone would realize the value of the stock and buy it back up.The bottom line here is that for every trade, you should have an “I’ve had it,sell the thing” stop. And for Anadarko, $39.99, one penny below $40 is my
162
TRADING PAIRS
number. The reason I have chosen $39.99 is that I want the stock to printbelow the whole number before closing the position. Sometimes a stockwill test a substantial support or resistance level and not penetrate it. Alsoof important note, more seasoned traders often prefer to put their stopsroughly 25 cents above/below a whole number, just to ensure that a coupleof cents on the opposite side won’t wiggle them out of their positions.Figures 22.22 and 22.23 voice both my concern and optimism for thetrade. Figure 22.22 shows that Apache’s stock fell beneath $70, which is critical support. I am very pleased with the trading action, as the stock is nowresting near ascending support. If it continues to fall and breaks the ascending line, longer-term ascending support near $64 could quickly become areality. This is good, good, good.Figure 22.23 is bad, bad, bad. Anadarko’s stock has made a bold movedownward and could be heading toward $40. In addition, the stock has violated horizontal support at $42, which does not bode well for bulls. Mythinking here is that the stock will hold above $40, as institutions buy thedips. Even though Anadarko hasn’t reported any good news lately, myinstincts tell me that somewhere out there lurks a merger rumor. However,we could be long gone from the entire trade before any such news surfaces.The trade is now up $790, or 0.70 percent. I would like to close the tradewithin the next three weeks, and to do so I will need some negative news fromApache, while Anadarko struggles to hold ground. (See Figure 22.24.)
FIGURE 22.22 APA 10/15
Trading Diary
163
FIGURE 22.23 APC 10/15
FIGURE 22.24 Trade Summary 10/15
Thursday, October 16Not much new here. The pair expanded a bit over the last day, with the differential now at 28.70; the trade is still positive, but is struggling to make any serious gains. The density curve is still hovering in the 0.995 area, which is positive for the overall picture. Figure 22.25 depicts the last few days of densitycurve data, where you can see that it has traded as low as 0.994, but could notfall lower. This is getting old, I’m ready to close the position for a huge winner.The profit has fallen to $160, which is obviously not a ton of money. Iwould also like to point out that Apache reports earnings in five trading sessions on the 23rd. (See Figure 22.26.)
164
TRADING PAIRS
FIGURE 22.25 Density Curve 10/16
Friday, October 17The trade has slipped negative, with the differential now at 28.97, seven centsabove the entry. Also, the density curve is once again headed higher and is nowat 0.996. While this alone does not worry me, the fact that the ratio is at 1.70 isslightly unnerving. But, to ease my mind, the third standard deviation has tickedupward to 1.73. This is important to note, as all of the descriptive statistics aremoving numbers that shift as each day provides more data. It is very importantto keep this in mind, and keep a close eye on what is happening with not onlythe trade and individual stocks, but the statistical data as well. Figures 22.27 and22.28 display the Main Page of the spreadsheet and the up tick in the ratio.
Monday, October 20Back on track, today the differential made a large move down to27.85, and our trade is yielding a profit of $1,010. Back in the black
Trading Diary
165
FIGURE 22.26 Trade Summary 10/16
FIGURE 22.27 Main Spreadsheet 10/17
again. Today is a huge day for our trade and what I think is the beginning of further convergence. The density curve has posted its lowestreading in seven sessions, while the ratio has fallen to 1.67. A breach of1.64 would be extremely positive for our trade, as it would be the firsttime the ratio has been below 1.64 since September 26, when I firstbegan looking at the trade. Statistically, it looks as if the pair hastopped out and is now beginning to contract. Figure 22.29 shows thedifferential, ratio, and density curve, followed by the usual trade summary in Figure 22.30.
166
TRADING PAIRS
FIGURE 22.28 Trade Summer 10/17
Tuesday, October 21Another day, another pullback. The differential ascended to 28.15, thoughthe trade is still positive. Despite the loss of profit, the trade is still in greatshape and is acting exactly as it should. The density curve up ticked to 0.994,while the ratio is still holding steady under 1.70. Apache closed below $70again, a good sign for our trade, especially right in front of earnings.Anadarko is hovering above $41, which is slightly relieving, but I would liketo see the stock rally out of dangerous territory here and post some realgains.The trade is now up $750—not exactly a huge winner, but positivenonetheless. (See Figure 22.31.)
Wednesday, October 22Today, the trade went against us a little farther and is now up a mere$180. Today’s trading action was to be expected, as stocks like Apacheusually rally ahead of earnings. Then, if the company does not reportblowout numbers, fickle investors will exit their positions into anystrength remaining. As mentioned before, Apache stands a good chanceof missing estimates due to charges related to currency fluctuations.Specifically, the weakening dollar should have some impact on the company’s bottom line. If such occurs, we can expect Apache to declinesome, and our pair will take another step forward toward profitability.The exhilarating part about today’s action is that while the entire oil sector was up, so was Anadarko. And every bit that Anadarko moves awayfrom $40, the better off the trade is. Figures 22.32 and 22.33 showAnadarko’s trading action for the day. The stock has now paved the wayfor a possible retest of the $43 range. Tomorrow is going to be a veryinteresting day for our trade.
Trading Diary
FIGURE 22.29 Density Curve 10/20
FIGURE 22.30 Trade Summary 10/20
167
168
TRADING PAIRS
FIGURE 22.31 Trade Summary 10/21
FIGURE 22.32 Anadarko Chart 10/22
Thursday, October 23Apache reported third-quarter earnings today of $276 million, or $1.69 ashare, up from $145 million, or 95 cents one year earlier. While this news isgood for the most part, the company missed the consensus estimate of $1.77a share. Of course, before charges it beat expectations; however, we lookonly at net numbers, and in this case the net number is a disappointment. Thecompany had a 34 percent increase in oil-equivalent production for the quarter, which is remarkable. Regardless, because the stock has run up so muchover the last two years, it would have taken some seriously whopping numbers to push the stock higher. In addition, the company said earnings wouldhave been higher, except that it had to take charges for unfavorable currency
Trading Diary
169
FIGURE 22.33 Trade Summary 10/22
exchange rates. I hate to bet against a company that doubled revenue yearover year, but at this point the stock is a sloth. I have no doubt that Apachewill come back in the near future to post another 52-week high, but for now,it will have to suffer while profit-hungry investors leg out of their positions.Figure 22.34 shows that Apache fell out of bed hard today, declining to the 50SMA near $68 before rallying into the close. Now that the stock has tested themoving average support, it stands a good chance of breaching it in the nextfew sessions. This is exactly the kind of trading action that we like to see. Notonly has the stock had a fundamental event that caused it to roll over, but ona technical level, it won’t be long before momentum traders begin adding supplemental pressure as well. From here, it is very possible that the stock willfall into the $65 area, better known as longer-term ascending support. I don’twant to completely count buyers out, as the overall trend is up, though fornow, our short side looks pretty good.Also encouraging, though Anadarko declined as well, the stock held uppretty well, indicating that sympathy selling—due to other oil companies—will not be much of a factor during this earnings season. For the time being,Anadarko is marching to the beat of its own drum.Our trade is now up $890 with a differential of 27.97. This is the firsttime that the differential has been below 28 since October 9. The densitycurve is still hanging out at the 0.993 level, which we would like to seebroken. For the time being though, the trade could not have more goingfor it, unless Anadarko makes a miracle merger announcement.(See Figure 22.35.)
Friday, October 24Another day, another dollar. The Apache earnings news was definitely goodfor the position, as both stocks moved in the right direction today. Apache fell,
170
TRADING PAIRS
FIGURE 22.34 APA 10/23
FIGURE 22.35 Trade Summary 10/23
while Anadarko climbed, exactly the combination we are looking for. What’smore, the density curve is at 0.992, the lowest point since September 30.The ratio has backed off of the 1.67 area, and the differential could soon bein the 26 region. Overall, the trade is working very well. We have been in theposition for 16 trading days and we are up 1.27 percent. Not a bad take forless than a month of trading.Apache continues to sit just above the 50-SMA and is the key to ourtrade’s success right now. We need the stock to violate the major movingaverage in order to bring momentum sellers and—dare I say—day traders inoff the fence to push the stock lower. (See Figure 22.36.)
Trading Diary
171
FIGURE 22.36 Trade Summary 10/24
Monday, October 27The pair began the week on a positive note with the differential shrinkingto 27.15 and the ratio falling back to 1.65. What’s more, the density curvehas fallen to 0.991, the lowest point since September 29. The trade is nowyielding 1.53 percent, or in dollar terms $1,710. Not a bad profit for less thana month of trading. There was no significant news on either stock today;thus, I am left with the impression that the stocks are still digesting therecent earnings information from Apache. Figures 22.37 and 22.38 showthat the stock has now fallen under the 50-SMA for the first time sinceAugust. In addition, the daily stochastics are now sitting on 20, and are indicating selling pressure. Should the indicator breach 20, the event wouldbring technical momentum sellers in off the fence. The MACD is approaching the 0 line, also signifying technical selling in the stock. The aforementioned events are a good sign for a continued pullback on the sell side of ourpair.
Tuesday, October 28The pair backtracked slightly, though the event is merely a technical blip withno significant news backing the move. In the previous entry for Monday, Imentioned that Apache was testing the 50-SMA. Generally, when a stock testsa major moving average, it does not