Regression charts?

[Martinghoul]

I was thinking more along the lines of net income streams/total return as I (probably incorrectly)assumed they would be holding.

Well, that could be a part of it, I suppose, but it's not a meaningful input by itself. It's just one of the components of the model, which tells you what's cheap and what's expensive. You then buy what's cheap, sell what's expensive and wait for it to normalize. That's the hope, anyways.

Presumably it would be a bad idea to have 100% of an account in pairs trades exposed to equities? Having said that, the market neutral factor should help balance the volatility?

Exactly... You always want a cushion and some dry powder. However, if done correctly (i.e. don't sell cheap options), relative value (RV) stuff can be a lot less volatile than outright.

BTW, I can't recommend Montier's stuff enough. His latest is here:
http://pragcap.com/7-immutable-laws-of-economics

 

[scose-no-doubt]

oh I see. So you'd be screening each individual component of the portfolio thing to maintain the desired exposure adjusting as necessary... or something.

 

[Martinghoul]

oh I see. So you'd be screening each individual component of the portfolio thing to maintain the desired exposure adjusting as necessary... or something.

Yep, something like that...

 

[SanMiguel]

Well, that could be a part of it, I suppose, but it's not a meaningful input by itself. It's just one of the components of the model, which tells you what's cheap and what's expensive. You then buy what's cheap, sell what's expensive and wait for it to normalize. That's the hope, anyways.

Exactly... You always want a cushion and some dry powder. However, if done correctly (i.e. don't sell cheap options), relative value (RV) stuff can be a lot less volatile than outright.

BTW, I can't recommend Montier's stuff enough. His latest is here:
http://pragcap.com/7-immutable-laws-of-economics

The worst thing I could imagine for a market neutral portfolio is to have the volatility increase too much so that 1 share goes out of kilter with the other.
In a market crash, you'd expect both stocks to go down, which is fine in principle as it's market neutral. Any ideas on what sort of cushion might be needed? It doesn't really happen that often. I guess I'd have to see what happened to some of the stocks during the flash crash.

 

[scose-no-doubt]

cheap long vol options?

 

[Martinghoul]

cheap long vol options?

Well, long or short vol is just your exposure when you're long or short options. In general, if you do RV, you need to be sure you're not being a greedy idiot and aren't selling tails (like AIG).

The worst thing I could imagine for a market neutral portfolio is to have the volatility increase too much so that 1 share goes out of kilter with the other.
In a market crash, you'd expect both stocks to go down, which is fine in principle as it's market neutral. Any ideas on what sort of cushion might be needed? It doesn't really happen that often. I guess I'd have to see what happened to some of the stocks during the flash crash.

Well, it's very very hard to generalize and that's where science turns into art. If you look at what went on during the crisis when all sorts of things were getting out of whack, lots of these trades went pear-shaped. There are two ways to address it: a) never have it on in a size that can kill you dead, esp if you're leveraged; b) always be long some options (given that any RV strategy is inherently short). But, ultimately, it's all about judgement and there's no right answers

 

[SanMiguel]

Well, long or short vol is just your exposure when you're long or short options. In general, if you do RV, you need to be sure you're not being a greedy idiot and aren't selling tails (like AIG).

Well, it's very very hard to generalize and that's where science turns into art. If you look at what went on during the crisis when all sorts of things were getting out of whack, lots of these trades went pear-shaped. There are two ways to address it: a) never have it on in a size that can kill you dead, esp if you're leveraged; b) always be long some options (given that any RV strategy is inherently short). But, ultimately, it's all about judgement and there's no right answers

I don't think pairs trades need to have a short bias, sometimes you are playing the long side of the spread as well.
I guess I should pick some of the good ones and look at what happened to the share ratios 1 week before and 3 weeks after the flash crash...

 

[scose-no-doubt]

I meant like a structured options trade. Something like howard cahodas strat in a mirror.

 

[Martinghoul]

I meant like a structured options trade. Something like howard cahodas strat in a mirror.

Well, you see, young Howard is doing precisely the sort of selling of options that gets RV peeps into all sorts of trouble.

I don't think pairs trades need to have a short bias, sometimes you are playing the long side of the spread as well.
I guess I should pick some of the good ones and look at what happened to the share ratios 1 week before and 3 weeks after the flash crash...

I didn't mean short... I meant "given that any RV strategy is inherently short gamma (i.e. short options)".

 

[SanMiguel]

Well, you see, young Howard is doing precisely the sort of selling of options that gets RV peeps into all sorts of trouble.

I didn't mean short... I meant "given that any RV strategy is inherently short gamma (i.e. short options)".

You'll have to explain that one please
Alpha, beta I get but gamma? (Don;t say Tokyo).

 

[Martinghoul]

You'll have to explain that one please
Alpha, beta I get but gamma? (Don;t say Tokyo).

Well, gamma in a sense of optionality... RV strategies are short optionality by construction.

 

[SanMiguel]

Well, gamma in a sense of optionality... RV strategies are short optionality by construction.

But that's options trading isn't it? With pairs trading, it;'s direct or leveraged exposure to long/short equities.
You're saying that the portfolio should be balanced with a long options hedge or long VIX hedge?

 

[Martinghoul]

But that's options trading isn't it? With pairs trading, it;'s direct or leveraged exposure to long/short equities.
You're saying that the portfolio should be balanced with a long options hedge or long VIX hedge?

Yes, what I'm saying is that these strategies have implicit short option-like exposure. But if you hedge it by just buying VIX or smth, it will erode your returns (there's no free lunch). So the only way it works is if you find cheap options out there...

 

[scose-no-doubt]

Thats what I was getting at in my post #14.

What I'm still unsure of is why could these type of funds not get a get similar exposure from a smaller $ in fewer securities?

 

[SanMiguel]

Thats what I was getting at in my post #14.

What I'm still unsure of is why could these type of funds not get a get similar exposure from a smaller $ in fewer securities?

Especially if they are market neutral. Even if the market goes down 10% in one day, does anything really need to be hedged? It makes sense not to leverage up to 100% in the account for sure.

 

[Martinghoul]

Thats what I was getting at in my post #14.

What I'm still unsure of is why could these type of funds not get a get similar exposure from a smaller $ in fewer securities?

You can get whatever exposure you want... The goal of these strategies is a) to achieve idiosyncratic returns (i.e. not returns related to guessing the mkt direction right); b) diversification; c) not be too short optionality (including the liquidity options).

So I guess I am not too sure what you mean.

 

[scose-no-doubt]

Sorry I was being an idiot again. I was assuming that they weren't businesses with new and existing clients adding and pulling funds.

Better to remain silent... and so on.

 

[SanMiguel]

You can get whatever exposure you want... The goal of these strategies is a) to achieve idiosyncratic returns (i.e. not returns related to guessing the mkt direction right); b) diversification; c) not be too short optionality (including the liquidity options).

So I guess I am not too sure what you mean.

But why have options at all in a pairs trading strategy?

 

[Martinghoul]

But why have options at all in a pairs trading strategy?

Because your strategy is implicitly short options, as I said...

 

[SanMiguel]

Because your strategy is implicitly short options, as I said...

Now, I'm completely lost
How is it short options when I buy 1000 shares in BP and short the same monetary amount in Shell?

If it's because volatility throws the pairs trade out if kilter then that's not necessarily true because the market doesn't stay volatile for that long. Perhaps 2007-8 and the flash crash are differing types. Long options could just as easily kill the trades off with spending money on options that expire worthless.