This is a guest post about spread trades written by Chris Cachat. Follow me on Twitter and StockTwits.
First off, I barely know what I'm doing here. I had never really thought about spread trades until I began following Michael Bigger (@biggercapital). The guy really seems to have a passion for spreads, and it's kind of contagious. Credit is also due to Aris David (@fledglingtrader) and @biggercapitalnw for posting some spread trades for me to study. Dynamic Hedge is really good with these too, so I thank him for some education too.
The spread I'm looking at is UNH - WLP. Below is a graph of the spread. I'll explain further.
Click image to enlarge.
The top graph is the price of UNH 42.59 / WLP 67.21 = 0.63.
Red line = 30 day linear regression line
Blue dotted line = 2 standard deviations away from the red line
Fuchsia line = 3 standard deviations away from the red line
The bottom graph is simply the price of a dollar neutral (almost) spread: 12*UNH - 7*WLP [Long 12 shares UNH, short 7 shares WLP]. I need this bottom chart so I can analyze the actual prices of my desired spread.
Reasons for Identifying this Spread
1. Both stocks are in the same industry
2. They are highly correlated 96.45% over the last year. Correlation = A statistical measure of how two securities move in relation to each other.
3. They are highly co-integrated 99.50%. Cointegration = the statistical confidence that a pair will revert to the mean. I think cointegration is the most important. High correlation means that over a given period of time, two stocks will move up or down in synchrony. But high cointegration means the two prices cannot wander too far off in opposite directions for very long before they eventually come back to a mean distance. Unfortunately, my Amibroker cannot calculate cointegration, so I rely of this nifty website Catalyst Corner. I run a trade report (see bottom of post) that confirms some of the things I'm reading on the charts.
4. It is over two standard deviations away from it's 30 day linear regression line. You can see at the beginning of 2011 the spread touched the bottom 3 STD line, then snapped back. It hit the upper range then came down to where it is today. I'm expecting similar action.
5. WLP is short term overbought in my book, RSI(2)>99.
Using Interactive Brokers, you can create the 12*UNH - 7*WLP spread and enter a limit order; they handle the price execution on each stock. That spread closed at 40.63 today, so I might place a limit order below that. I would be buying a price that is statistically very far from it's mean, and likely to revert back.
Exit Strategy
I'm still trying to figure this part out, but I think I'll look to exit when the spread price gets back to it's 30 day regression line, which it $53. I don't know though; I may just use discretion. I'm treating this as a short term trade, so I'd like to get out in a few days.
UNH and WLP are slow movers and I don't really expect fast action, so I think they're good to learn on. When I get more comfort with spreads, I'll look to more volatile stocks. They're not even going to make me big $$, but that's OK. If I got in at $40 and exited at $53, buying/selling $10K of each stock, it would be about $260 profit.
Difficulties I've Encountered
Finding trades on a daily basis! I wish I could just write a code in Amibroker that would scan stocks and give me the spread ideas. I can't though. I think I need to just pick a few spreads that are highly coointegrated and watch them all the time. I'd look for similar scenarios I see with UNH - WLP.
Backtesting - I haven't figured out how to code this in Amibroker. Being a quant (albeit Simple), I feel more comfortable making trades that have some backtested results. I need to work I my coding skills, but in the meantime, I'll really on my human brain and real time trades to figure this out.
Why I'm Trying These
To do something new and expand my trading repertoire. If I can sprinkle a spread strategy with my other strategies, it can benefit my bottom line.
Most importantly, I view a spread trade differently that just a regular 'go Long' or 'go Short trade'. Sure, I want UNH to go up and WLP to go down; that would be ideal. But the way I really look at it: I want UNH to go up faster than WLP or I want WLP to go down faster than UNH. I'm not trying to be green on each stock, just green on the spread. So I'll probably have one winner and one loser, but overall net positive. Also, there's less anxiety about market direction.
So there it is. This spread stuff is a work in progress. I'm just glad I found some cool people in twitterland that introduced me to the idea. I know I'm not considering many factors like half life or Pearson correlation, but in due time. Let me know if I am on the right track.
Cheers!
This is the Catalyst Corner report, click to enlarge
Click image to enlarge.