Get a Half-Life

What is the half-life of a spread and how do you use it in practice?  For a mean-reverting spread, half-life is the time it takes for the spread to revert to half its initial deviation from the mean.  It is measured in trading days.  Half-life can be derived from  Ornstein-Uhlenbeck’s mean-reversion equation.  It is calculated as

 

Half-Life =- ln(2)/theta

where theta is the estimate of the rate of mean-reversion. The half-life of a spread has two main purposes.  First it can be used to determine whether or not to enter a spread.  We prefer spreads with a half lives under 50 days.  There are no real rules for this however and if you don’t mind holding positions for a longer period you can use a longer half life.  Half life can also be used to determine the holding period for a mean-reverting spread.  In other words it can be used as a stop loss criterion.  If a spread hasn’t hit its exit target within the period given by the half life, the trader would exit the trade.  Again there is no rule that says a trader has to exit a position at the end of the half life, but it is a useful indicator as to whether the relationship between the two securities has changed.

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

About Stocks Cointegration

Cointegration is a confidence level that when two securities (long and short) deviate in valuation, they will revert to the mean.  Here’s a more technical definition given by economists Robert Engle and Clive Granger:

"If each individual stock price series exhibits a random walk (non-stationary) but a linear combination of them is stationary, then they are said to be cointegrated.”

Cointegration is an essential part of our statistical based spread trading strategy.  Because this strategy entails trading in and out of numerous spreads we can’t possibly know everything about all of the securities we trade.  Instead we use the statistical history of a spread as a proxy for detailed knowledge of each security.  We believe that over the long run (but definitely not the short run) the law of one price is enforced in financial markets.  That is if two securities have the same payout they will have the same price.  We are interested in finding spreads that when they have deviated from the law of one price in the past, consistently returned to that price.  The cointegration confidence interval tells us the likelihood that we have found such a spread.

Suppose you trade spreads on fundamentals only.  Can you also use cointegration?  Why not?  As we have said before, mash up different ideas and recipes.  There is no reason why a trader can’t combine different trading approaches.  We will write more about some of these statistical approaches in the future.

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

Trading Turnaround News with a Spread

On July 6, disk drive component maker Hutchinson Technology ($HTCH) pre-announced stellar results for the quarter ended June 30.  Shares were up almost 20% in pre-market trading.  The stock has performed very poorly in recent years, falling from a high in 2005 of over $40 to just $2 last month.

Shortly after the open we bought the spread 50*HTCH-1*SPY.

The company reported an increase in it’s top-line sales number of 14%.  The CEO said he expects this increase to continue into the coming quarter.  The company has positive Free Cash Flows and reasonable levels of debt.  With these solid fundamentals, we think the downside risk is reasonable compared with the potential upside if the trend turns around.

Below is the chart of the spread since the announcement.  As you can see, the spread traded higher on Wednesday, Thursday, and Friday.  On Friday it broke through resistance and traded as high as 22 before closing at 19.  We continue to hold the spread.  The company is expected to announce earnings after the close on July 26. We will most likely be out of the position by then.

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

Gold Spread Redux

Yesterday we sold the $GLD -$GDX spread.  We had shorted this spread back in March.  Over the next few months the spread continued to move higher so in early June we finally decided we had enough and unwound at a loss.  About two weeks later we saw the following post:

http://www.robertsinn.com/2011/06/21/new-pairs-trade-gdxgld/

At this point we were tempted to jump back in but decided to wait until we were more confident that the spread had turned around.  We wanted to see the spread consistently decline for a couple of weeks before shorting again.  We would be giving up potential profit but we would be more certain the spread would go our way.  Yesterday The Stock Sage unwound his position for a nice gain (see link):

http://www.robertsinn.com/2011/07/07/update-gdxgld-pairs-trade/

Off course we would have liked to enter the trade at his levels but we feel this one has a long way to fall and our first concern in re-entering the trade was evidence that the spread had turned around.

More often than not, we will share our more challenging experiences with spread trades. You can use our experience for your own benefit. When we make money using statistical methods, it is a dryer experience to share with you.

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

The Market Gets This One Right

On June 28^th, Accenture Plc ($ACN) climbed 3.2 percent to $59.65, the highest price since it went public in July 2001 on the announcement that the firm will replace Marshall & Ilsley Corp. ($MI) in the S&P 500 after the close of trading on July 5th.

We had shorted $ACN the prior day as part of a pair trade.  This move had triggered a stop loss and we unwound the trade for a 6% loss.  But if you look at a graph of $ACN you can see that the stock had begun a sharp upward move about a week earlier. It was this earlier upward move that signaled to us that the stock was rich relative to Automatic Data Processing ($ADP). Most likely, the inclusion of $ACN was already getting priced in.

That’s one of the risks of trading spreads.  Often, the market is right and the spread widening is warranted.

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

Hurry Up and Wait Please

My patience on Sketcher's ($SKX) seems to be working. It was up nicely yesterday. The news from Nike ($NKE) , Crocs ($CROX), Timberland ($TBL) et al are boosting interest in this sector.

Sketchers is a battered down value stock. Other than defining the idiom "A rising tide lifts all boats", what else is happening here? Well, I do see change. Sketcher's main customer Brown Shoe ($BWS) had a good earnings report last week. I hope this is a sign that the stuffed inventory channels are thinning out. Sketcher's has its own e-commerce shoe website. Its shoe prices for their "Toner shoes" seem to have come down slightly. I am hoping that their new pricing is the adjustment needed to boost demand. Looking at the upcoming seasons, the "Back-To-School" and Christmas sales will help tremendously.

Sketcher's is the only publicly traded company that sells the "Toner Shoe" style. Reebok & Asics are the other main sources of this style of shoe and are privately owned. If you want a stake in this new market and you're not Warren Buffet who can buy the whole company when he likes an equity, then $SKX is your only choice.

The controversy seems to be that Sketchers is now trying to enter and compete within the crowded fitness shoe arena. “Skechers Fitness has grown from a single style into a performance running line, training line, and an everyday toning line,” Skechers President Michael Greenberg said in a statement. "The apparel collection will build on the company’s Sketcher Fitness Footwear line, which now includes technical running shoes as well as styles designed for training and all-day wear." The new line is coming in 2012.

According to SeekingAlpha

Sketchers’ current attempt to expand the recognition of its brand into other realms of footwear may invariably diminish the perceived and/or actual focus of the brand on providing products appreciated by loyal consumers. Skateboarders and individuals who wear toning shoes appear, at least at first glance, to be unrelated groups of consumers....

How can you rate the current sentiment?
Comparing the current quarter earnings to last year's quarter, the results will be more of a measure of progress than an actual beat; However, the current consensus is that there will be vast improvement in the last half of the year.

The next earnings report is July 25th. Barring an early press release announcement, what could you use to read the current sentiment on SKX? The July 2011 options expire on July 15th, before the reporting period and the August 2011 options expire after the report.

Using the premise that an option straddle is a hedged bet composed of calls and puts can a price range be defined by the break-even points? I would like to experiment with a weighted blend of prices for a range of options for the next 30 days. Just like the VIX, would you be able to find a range of prices, and actually measure the incremental wisdom of the total crowd? The VIX volatility index is used by options traders to calculate options premiums (i.e. options prices), and also by S&P 500 traders to determine the expected daily range for the S&P 500 stock index and futures market. Only I would be doing it for one stock. The math may be over my head. Need to do more homework....

It seems to be a very volatile range. Prior to yesterday's run-up the range was quite different than this morning. But a simplified historical range of stock prices might be a more powerful piece to the puzzle that I thought.

Guest post written by Michael G Moore. Follow me on Twitter and StockTwits.

Sex Sells, Bargain Basement Price

We are analyzing a special situation with American Apparel ($APP). As background, $APP secured rescue capital from Michael Serruya and Delavaco Capital on April 26 to help $APP avoid filing for bankruptcy. The company was able to re-negotiate the terms of their debt to avoid default provisions triggered when 2010 financial statements contained a “going concern” clause. At that time we initiated a very small long position in the stock, and we have been monitoring the situation ever since.

We think $APP offers a good risk/reward profile, with high risk but higher reward potential. It gets even better if the final deal goes through.

Today $APP announced plans to replace 2 of their directors. We think this is good news for the stock, and we added to our small position. Here are the main points:

● Serruya and Delavaco Capital bought 15.8mm shares at $0.90 per share. They have the option to buy another 27.4mm shares at $0.90 within 6 months of the initial investment [October 26]

● As part of the terms of the investment, the CEO of the company has an anti-dilution provision. If $APP reaches stock price performance goals of $3.25 by 2013, $4.25by 2014, and $5.25 by 2015, the CEO receives a total of 39.7mm additional shares. The likelihood of trading at these levels is elevated.

● The company’s 2010 sales were $533mm. Costs are high in both Cost of Goods and Selling / General & Administrative costs, but with some cost-cutting measures the company may be able to return to profitability.

● Total debt is well-collateralized:

Long-Term Debt as of Year End 2010: Total $139mm
Revolving Credit Facility at Bank of America, $75mm, $53.4mm is drawn, due July 2012
Term Loan at Lion, $81.2mm matures Dec 31, 2013

Assets as Collateral for Debt (as of Year End 2010): Total $287.3mm
Cash $7.6mm
Accounts Receivable $16.7mm
Inventory $178mm
Property and Equipment $85mm

● The company may now have enough time to return to profitability before cash runs out. The current rescue investment is for $15mm immediately plus an additional $25mm over the next 6 months at the discretion of the investor, for a total potential cash infusion of $40mm this year. Total cash usage for operating activities was $32mm in 2010, although it should be noted that in 2010 the company reduced inventory by $37mm (20%).

● The company is scheduled to announce earnings on August 1.

● All bets are off if the final tranche of the deal does not go through.

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

Update on Thursday, July 7, 2011 at 12:32PM by Michael Bigger

Today APP announced sales numbers for the quarter ended June.  Sales were flat relative to last year’s June quarter, $132mm, despite a decrease in the number of stores.  We think this is very positive for the company.  Wholesale sales were down 4%, with the implication that retail / online sales made up the deficit.  We think this is a positive for operating margins.  We think of this company as a potential turnaround story, and today’s news represents confirmation that numbers are starting to turn around.  The earnings report is scheduled for August 1.

Apple and Salesforce.com Spread Temptation

In our statistically driven spread book we occasionally come across a spread that we had traded a few weeks before for a profit, which has returned to the price in which we originally entered the trade.  If the spread still meets all of our statistical criteria we will happily enter the trade.  But what do we do if all the criteria aren’t met.  It might be tempting to trade anyway, after all if the entry level is the same as it was two or three weeks ago, why not? But we believe the correct thing to do is to adhere strictly to our process. We started thinking about this earlier this week as a spread we had traded successfully in May, $AAPL - $CRM, approached the price at which we had entered the trade in late May.  But this time the stats said the spread was no longer cointegrated, and since cointegration is a major component of our trading rules we won’t trade this one again until it is cointegrated, even if it does hit the original level.

 

To be honest we haven’t always held fast to our processes, but we know we are better traders when we do.

      

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

CockRoach Theory Applied to SuperValu

SuperValu ($SVU) is a company that we have been following since it’s most recent earnings release on April 14.  The stock has performed poorly in recent years.  On April 14 the company announced earnings of $0.44 compared to consensus estimate of $0.34.  The stock opened up 12%.  Since then, the stock continued to rally for a few weeks before declining back to below the post-earnings level.  It has rallied slightly from the lows of last week: 

 

Click to enlarge.

 

 

$SVU is scheduled to release earnings on July 25.  Consensus estimate is $0.33 per share, significantly below last quarter actual $0.44.  We think there is value in Supervalu ahead of this earnings release. Competitors, including $WINN and $KR, reported strong earnings recently, and the Cockroach Theory states that whenever you see a roach there are usually more hiding.  In this case the competitor earnings are the visible roaches, and we think SVU is hiding a roach (good earnings) as well.  

 

The chart below shows $SVU in blue compared to $WINN in red and $KR in green.  As you can see, $SVU has declined significantly compared to its peers since the weeks following its last earnings release.   It has started to tick higher, but we think it has more room to run ahead of July 25 earnings. This is the bias we have in trading $SVU at the moment. We are very active in trading spreads of $SVU against other instruments:

 

Click to enlarge.

 

 

$SVU has a new management team focused on cutting costs and branding. Consumers are still budget-conscious, to the benefit of low-cost grocery stores such as $SVU.  When investors start to focus on the next round of earnings, SVU could benefit.  That said, there are risks to our bullish view. Grocery retailing is a competitive business.  $SVU still struggles to draw customer loyalty to its brand, and big chains like $WMT and $TGT continue to expand grocery product offerings.  $SVU faces an uphill battle against these competitors and a headwind of high unemployment and fears about the economy.

 

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

Beauty Contests

I want to thank Twitter user bluenextbear for bringing this article to my attention. I enjoyed it so much, I decided to share it with you. - Michael

 

Who's a pretty boy then? Or beauty contests, rationality and greater fools