Weekly Spread Re-Cap 4-01-11

This week we thought we’d talk about a couple of losing spread trades.  You can’t expect to get every trade right, so you have to develop a process for dealing with losing trades.

Our statistical arbitrage book is relatively new so we only recently developed firm rules for what trades to put on, and even more recently for when to unwind both profitable and unprofitable trades.  We are trying to avoid the situation in which we unwind our winners too soon, and keep our losers on for too long.

At the beginning of the week we decided we had a few losing spread trades on our book for too long.  We’ll briefly discuss two of them, 5*ENB (Enbridge) - 4*BPL (Buckeye Partners), and 5*AMAT (Applied Materials) – 2*VSEA (Varian Semiconductor).  We were short the first and long the second.  We entered the AMAT-VSEA trade on February 10^th.  By March 28^th, forty six days later, the spread was trading about $8 below where we bought, but because our initial statistical analysis indicated the spread should have reverted to its mean within a shorter time period, we decided to unwind.  The situation regarding ENB-BPL was similar.  This spread was trading $22 above the price we shorted it.  But the spread had been on the books too long and was not behaving as expected, a possible indication there had been a structural change in the relationship of the pair.

It’s sometimes psychologically difficult to unwind a position at a loss, and we don’t recommend using stop losses for every trading strategy.  Yet by doing so, you often avoid bigger losses.

Written by Norm Winer. Follow me on Twitter and StockTwits.