SpreadTraderPro Video

He Who Knows the Potential Wins

You can define potential energy as the energy required to move an object from height a to height b.

The potential energy in a value investment relates to the difference between a stock's intrinsic value and its current price.

In a pair trade, the z-score relates to its potential energy.

and so forth...

Knowing both numbers helps you win. Makes sense?

Written by Michael Bigger. Follow me on Twitter and StockTwits.

Blue Nile Versus Computer Sciences Pair

Here is the spread we are discussing in the Forum. http://goo.gl/625zN

• @fledlingtrader thinks that if you sell that one you might have to sit on it for a while (long half life).
• @biggercapitalnw wanted to sell it but NILE borrow is tight. Half Life is right on the border for 2 years but within range for other time periods.
• I think it might be a very good sell at 3 zscore, but might need to be patient.

 The tightness in the borrow is the major factor. Still a good spread candidate for discussion.

Written by Michael Bigger. Follow me on Twitter and StockTwits.

 

 

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The Market is Energy

The market is energy. On any particular day, think about the energy needed in order to move one unit of capital (a security) by a distance y (unit of stock price). Think about all the energy required to move all the capital market securities in the U.S market at any given point in time. The amount of energy required to accomplish this transition must be substantial, almost infinite. Think about the traders’ actions and reactions, the news, the liquid networks transporting market information, the value created or destroyed at each of the companies listed on the exchange over that unit of time, and so on. Astounding, isn’t it? Stock prices ebb and flow.

The trader or investor’s purpose is to harness market energy to his own advantage similar to Hydro Quebec’s purpose of harnessing the flowing energy of massive rivers in Quebec to the benefit of its population.

Hydro Quebec does not build its dams along marshes. Hydro Quebec has acquired engineering insights about the location of potential hydro energetic sources. They make money harnessing this energy and transporting it to where it is needed.

In my experience, most market participants have it upside down. They fall in love with a technique (technical analysis, value investing, day trading, pairs trading, and so on), and they try to apply their techniques to the most promising market situations. Market energy, which is fleeting, possesses this devilish ability to frustrate the application of most techniques developed for the pursuit of profit. However, by viewing the market as energy, you become less dismissive of other approaches. You use the most appropriate technique for the task at hand.

Does this make sense?

Written by Michael Bigger. Follow me on Twitter and StockTwits.

The Big Pairs Debate

Michael and Jennifer have different views on a critical issue regarding statistical pairs/spreads.  The question is whether the two companies need to be similar (in the same sector or industry) or not.

The basic pillar of spread trading is that the two stocks are tied together with some sort of force, and a deviation from historical levels is an opportunity to bet on a return to those levels.  Without such a force, the spread may not ever return to past levels.

Michael’s view is that all stocks are subject to the Law of One Price (LOP), this is the force uniting all securities.  “Ingersoll (1987) defines the LOP as the “proposition…that two investments with the same payoff in every state of nature must have the same current value””(Gatev, 2006), regardless of whether the two companies are in the same or very different businesses. The profit generated by the arbitrageur is a compensation for enforcing the LOP.

Jennifer’s view is that current price is expectation of future cash flows which are impacted by many outside forces.  Companies that have similar businesses will be impacted similarly by small changes to inputs like interest rates or commodities prices or consumer sentiment. A deviation in the prices of a bank versus an oil company may be an anomaly, or it may be due to fluctuations in inputs which could take a long time to correct; for similar companies it is more like to be an anomaly we can exploit in the short- to medium-term.  Given a relatively short time horizon, it is essential that the two companies have similar businesses.

This is an important issue because requiring the pair to be similar companies means fewer potential trading candidates and therefore less diversification across positions.  However, if we open up to pairs of different companies we may introduce more data mining errors.

What do you think?  Do you think statistical spreads need to be pairs of similar companies, or can you make money trading statistical spreads with companies in different industries?

Written by Jennifer Galperin. Follow me on Twitter and StockTwits.

In collaboration with Michael Bigger. Follow me on Twitter and StockTwits.

You can learn about trading pairs here.

Day Trading Green Mountain Coffee and Diamond Foods Spread

I have been day trading (scalping this spread) for the past few days. Everytime it goes close to about 20.00, I would initiate a short position.  That is short 3 * $GMCR / Long 5 * $DMND. I would then cover below 15.00 giving us +5 pts profit per spread.

Overall the spread is in overbought territory as it is trading over +4 z-score above the 5 year average.

Stats and charts can be viewed here. Learn to daytrade spikes and gaps here.

Written by Aris David. Follow me on Twitter and StockTwits.

Source: Interactive Brokers

More on Starting Over

My most popular post on StockTwits has been Starting Over. That post crushed it.

Before I forget, there are a few more things I would like to share with you:

• Not all tools have been created. Imagine the ultimate trading tool you would love to have. Now go build it.
• Make that tool algorithmic, in some way, if possible.
• Start building a business around it.
• Anchor it to the Internet.
• Now go and do some amazing things.

Written by Michael Bigger. Follow me on Twitter and StockTwits.

Introducing SpreadTraderPro

When I traded single-stock derivatives at D. E. Shaw, my boss traded S&P options spreads, and he made money consistently though he took very little risk. He was a trading magician. He knew his options market, especially the S&P, and he knew how to trade spreads. He constantly traded in and out, squeezing juice out of the lemon. The lemon never ran out of juice! It was a wonderful thing—a winning trading method.

Most of the best traders I have met trade spreads. They spread different options, stocks versus stocks, indices, stocks against indices, etc. They even trade cash against stock. Think of it as trading a stock against its intrinsic value. This is taking advantage of a spread between two values. The number of combinations is endless.

These traders are good at identifying pockets of value (be it statistical, against value, momentum, and so on) among the securities they trade, and they rotate their inventory to take advantage of these discrepancies with no net increase in market exposure.

On the statistical front, the biggest challenge is dealing with data; you have to narrow down the universe of stocks and spread candidates (millions) into the small subset of spreads that are cointegrated, meaning they tend to revert to the mean. This alone has made it very difficult for individual investors to trade statistical spreads. You may have encountered this problem if you have used our free Spread Analyzer, only to find out that very few of the spreads you can think of are in fact cointegrated at any significance level. It’s very frustrating!

We faced the same issue. We dealt with it by developing our proprietary market scanner to identify cointegrated spreads. Now, for the first time ever, we are making this tool available to the broader trading community. It is called SpreadTraderPro.

Say goodbye to the frustration of searching manually for profitable spreads. Using SpreadTraderPro, you can trade statistical spreads just like the pros do. No programming is required. It really is that simple!

Are you ready to complement your current trading strategies with statistical spreads for more profits and diversification? Click here to find out more about SpreadTraderPro.

Written by Michael Bigger. Follow me on Twitter and StockTwits.

Join The One Percent

I recently went to dinner with several friends who are traders at large investment banks. All of them are smart successful guys with many years of trading experience. I was explaining to them some of the statistical techniques we use at Bigger Capital. None of them were familiar with any of the basic statistical measures used in statistical arbitrage. I’ve encountered the same thing talking to other traders on different occasions. Ninety nine percent don’t have any idea of the basic concepts of statistical trading. And yet none of these measures are new. Statistical Arbitrage has been used as a successful strategy since the 1980’s. So what are the basic measures used? We give brief definitions of the primary ones below. They are the same statistical values we provide subscribers to our SpreadTraderPro. These measures can be used as a standalone strategy, or combined with other methods to enhance returns. They are:

1. Cointegration – measures the degree of confidence that a stock pair which has diverged from its mean value will revert to that mean.

2. Z-Score – measures the distance the spread is from its mean value in standard deviations.

3. Half-Life – is the expected time it will take for the spread to revert half way to its mean.

4. Zero Crossing Rate – is the number of times the spread can be expected to cross the zero value for the defined time period. A higher number implies a shorter holding period and a greater likelihood that the spread will not continue to trend.

5. Sum of Least Square - is the squared distance over the selected period. The lower this number the tighter the spread is, and the better the chance that the price of leg one will not wander far from the price of the leg two.

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

Green Mountain Coffee and Peet’s Coffee Spread

The $GMCR and $PEET spread is going to be a fun spread to trade during the next few days. The spread went from overvaluation a few months ago and it should trade in undervaluation territory today. You can play around with our Spread Analyzer right here.

- Michael