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How to Trade Spread

Table of Content
Disclaimer ........................................................................................................................................ 4 What Is Spread Trading? .................................................................................................................. 6 Why Trade Spreads? ........................................................................................................................ 7 The Art of Becoming a Better Trader ................................................................................................ 9 Spread Trading Mechanics ............................................................................................................. 11 Types of Spreads ............................................................................................................................ 13 Choosing a Spread ......................................................................................................................... 14 Statistical Methods ....................................................................................... 15 Non-Statistical Methods .................................................................................. 24 1. Trading on Bottom-Up and Top-Down Analysis (Value Investing) .............................. 25 2. Merger Arbitrage .................................................................................... 26 3. Liquidity Gap Spreads .............................................................................. 28 4. Trading the News .................................................................................... 31 5. Day Trading Spreads ................................................................................ 43 6. Dual-Class Shares ................................................................................... 46 7. Patterns .............................................................................................. 47 Combining Different Methods ........................................................................................................ 48 Execution Technology ..................................................................................................................... 50 Risk Management .......................................................................................................................... 52 Exit Price ........................................................................................................................................ 54 Special Topics ................................................................................................................................ 56 What Else Can We Trade Against This? ................................................................ 56 How to Use a Spread to Form a Directional Opinion .................................................. 57 Creating Signals ........................................................................................... 59 Market Versus Predictive Spread 1 .................................................................. 59 Volatility Spread 2...................................................................................... 60 Consumer Sentiment Spread ......................................................................... 61 Interest Rate Spread ................................................................................... 62 Gold Spread ............................................................................................. 63 Creating Your Signal ................................................................................... 64 Trading Statistical Spreads Around Earnings Dates ................................................... 66
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Dividends .................................................................................................. 67 Carry Costs................................................................................................. 68 Contango/Backwardation ............................................................................... 69 Trading Options ........................................................................................... 71 Creating a Playbook ...................................................................................... 75 Conclusion ..................................................................................................................................... 78 Additional Material ......................................................................................................................... 79 Join the One Percent ..................................................................................... 80 The Big Spread Debate ................................................................................... 81 Trading Insider Purchases ............................................................................... 83 I Wish I Had Learned to Trade This First ................................................................ 85 Darwin the Trader ......................................................................................... 88 Learn To Trade Like a Math Geek ....................................................................... 90 Spread Trading and Takeovers .......................................................................... 91 Taxes ....................................................................................................... 92

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Disclaimer Disclaimer
THE COMPANY, AS WELL AS ITS AFFILIATES AND ITS PARTNERS, SHALL NOT BE LIABLE FOR ANY DAMAGES OR COSTS OF ANY TYPE ARISING OUT OF OR IN ANY WAY CONNECTED WITH YOUR USE OF THIS INFORMATION. THE CONTENT IS PROVIDED AS IS AND THE COMPANY, AS WELL AS ITS AFFILIATES AND ITS PARTNERS, DISCLAIMS ANY AND ALL REPRESENTATIONS AND WARRANTIES, WHETHER EXPRESS OR IMPLIED. THE COMPANY CANNOT GUARANTEE AND DOES NOT PROMISE ANY SPECIFIC RESULTS FROM USE OF THIS INFORMATION. THE COMPANY DOES NOT REPRESENT OR WARRANT THAT CONTENT, OR MATERIALS IN THIS MANUAL OR ELSEWHERE ARE ACCURATE, COMPLETE, RELIABLE, CURRENT, OR ERROR-FREE. The information contained within this booklet is provided for informational purposes only and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. Presentation of the information via the Internet is not intended to create, and receipt does not constitute, a tax planner/client or financial planner/client relationship. Internet subscribers, users, and online readers are advised not to act upon this information without seeking the service of a professional tax and/or financial planner. The Company reserves the right to change any and all content at any time without notice. Reference to any products, services, processes, or other information by trade name, trademark, manufacturer, supplier, or otherwise does not constitute or imply endorsement, sponsorship, or recommendation thereof, or any affiliation therewith, by the Company. The information in this manual does not contain a recommendation for any particular security or investment.
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The Company is not a registered broker-dealer and does not endorse or recommend the services of any brokerage company. The brokerage company you select is solely responsible for its services to you.

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What is Spread Trading? What Is Spread Trading?


Spread trading, also known as pairs trading, is a strategy of trading one or more
securities simultaneously by buying one security or multiple securities and shorting another security or multiple securities. The two sides combined consist of a pair. The difference between the prices of the two sides is the spread. The term pair trade is more commonly used than spread trade, and it almost always refers to statistical arbitrage (more on this later). We usually use the term spread because we do not do all of our trades on a purely statistical basis, and in theory, the trade could involve more than two securities on one or both sides. We will thus use spread trading throughout this booklet. Of course, spread traders will buy the side that they believe will outperform the short side. For example, suppose you believe Pfizer (PFE) is cheap relative to other drug makers and, in particular, relative to Eli Lilly (LLY). You have a few options. You can buy PFE, but if the broad market declines, PFE might also decline. You can reduce this risk by trading a spread: buy PFE and sell LLY, buy PFE and sell XLV (health care exchange traded fund (ETF)), or buy PFE and sell a basket of drug-maker stocks. In this booklet, we will discuss how to choose which spread to trade in detail.

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Why Trade Spread? Why Trade Spreads?


At Bigger Capital, we trade spreads to generate profit while minimizing net market exposure. When trading a spread, you are betting on relative performance rather than on absolute performance. This allows you to express a view without taking on unwanted risk. There are several advantages to this approach:

It maintains market neutrality, reducing exposure to the overall market direction. It reduces sector and industry risk, depending on the short security chosen. It reflects the differential economics by removing factors outside the scope of the trade (market noise). It improves your ability to compare and analyze. It is self-funding because you can use the short-sale returns to buy the long position (subject to margin requirements).

Of course, spread trading has some potential risks as well:


Reduced risk can reduce profit potential. Further divergence between the legs can lead to a loss on both legs of the trade. You may face increased exposure to short risk on the short leg, with the potential for a short squeeze. Few brokers offer spread-trading capabilities (e.g., Interactive Brokers combo trades), making it complicated to execute and track.

And thats not all. Because the concept of cointegration, which is central to spread trading, is a measure of the statistical elastic force between two securities (more on that later), we can use spread trading to implement more effectively directional or volatility trading strategies.
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We can even create signals using spreads to try to predict the direction of the market or sector and so forth. For all these reasons, mastering spread trading will elevate a trader and investor to a higher performance level.

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The Art of Becoming a Better Trader The Art of Becoming a Better Trader
When I traded single-stock derivatives at D. E. Shaw, observing my boss trade S&P options fascinated me. He made money consistently, though he took 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. He started his career trading options for OConnor & Associates and then worked for Swiss Bank before joining D. E. Shaw. Both of these were great trading houses at the time. Most of the best traders I have met trade spreads. They spread different options, stocks versus stocks, indices, stocks against indices, and the like. The number of combinations is endless. Spread traders are good at identifying pockets of value among the securities they trade, and they rotate their inventory to take advantage of these discrepancies with no net increase in market exposure. The Twitter financial stream is populated with one-dimensional risk-augmenting trading ideas. Most of these ideas are actionable in isolation, but they are not suited for traders seeking to compound wealth by deploying capital optimally with a constant risk profile. The art of becoming a much better trader requires gaining exposure to spread trading. When you start looking at the trading world from the point of view of trading one security against another, you will:

Analyze the economics of both legs. Hone your ability to identify value within the set. Remove some of the market noise from the equation.
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Establish a better basis for comparison and analysis. Investigate new areas for exploration. Understand the meaning of hedge. Think in terms of capital efficiency and velocity. Discover powerful trading patterns not visible using traditional charting methods.

If you are still skeptical, then check out Charlie DiFrancescas trading video. If I had to recommend just one trading video, this video would be it. He filmed this video in 1989, and it is a must-watch for all traders. Here is a cool example of how we recently applied Charlie Ds advice. After the market closed on June 28, 2012, this tweet from Aris David caught my attention: FYI, Europe covered before the close FTSE last minute rally $EWU Our signal (more on building your own signal later on) had a super strong buy signal going into the close of the U.S. market, and we were waiting for a dip to buy. After the market closed at 4 p.m., the S&P futures went down seven points, and we decided to buy a bigger futures position based on our signal and Aris s information. We thought someone knew something about Europe given how the FTSE closed, and the S&P selloff presented an attractive opportunity. We had more conviction, so we committed. That is what spread trading is for us. It means trading the relationships not only the statistical relationships between stocks, but information against information, a stock price against its intrinsic value, and price against news. Spread trading is about exploiting two levels of potential energy and their relationship. The next day, the market went up about 2%. Someone knew something, and we exploited it.

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Spread Trading Mechanism Spread Trading Mechanics


When you trade spreads, the mechanics are not as simple as with single securities. Suppose you think, for some reason, that ABC will outperform XYZ. So, you want to buy the spread ABC XYZ.

Figure 1. SpreadTraderPro Scanner

If ABC is trading at $20 and XYZ is trading at $10, then you need to compensate by trading two shares of XYZ for every one share of ABC. Another way to think about this is that if you want $10,000 exposure on each stock, you need to buy 500 shares of ABC and sell 1,000 shares of XYZ (ratio of 1 to 2). The concept of notional exposure is also important for calculating profit (or loss). Suppose you buy the spread 1 * ABC 2 * XYZ at a level of 0. To get to my $10,000 exposure on each stock (or leg of the spread), you buy 500 spreads, which means you buy 500 shares of ABC and sell 1,000 shares XYZ.

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Now assume you are right and ABC increases to $30 while XYZ goes up to $11. Your spread is now trading at $8 = 1 * $30 2 * $11. If you close the position, your profit is $8 per spread * 500 spreads = $4,000. You could also calculate that you made $5,000 on your long ABC position, but you lost $1,000 on your short XYZ position for a net profit of $4,000. But what is your return on capital? Typically, we look at return on long (or short) capital, which is a more conservative return number. In this case, we started with $10,000 exposure on each leg of the trade. Total profit was $4,000. Return on long (or short) exposure is $4,000 / $10,000 = 40%. You could also consider return on leveraged capital, which varies depending on the margin requirements you face. If you put up 30% margin on each leg, you will need to have $6,000 cash in the account to do this trade, so your return is $4,000 / $6,000 = 67%. Some brokers allow you to trade spreads easily through multi-leg orders. Interactive Brokers, for example, has a combination order feature that allows you to trade both legs of a spread with one order. Please see our video about Interactive Brokers combo orders for detailed instructions. If your broker does not have this feature, you will need to track the spread levels manually using a spreadsheet. Once the spread reaches your desired entry (or exit) point, you enter an order for each leg of the spread.

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Type of Spreads Types of Spreads


In this booklet, we will discuss spreads that have a linear payout, such as stocks, baskets of stocks, or ETFs. Spreads involving derivatives and other nonlinear securities such as options, futures, and interest rates are beyond the scope of this booklet. In its simplest form, the spread is defined to be dollar neutral, which means the notional exposure on the long side will equal the notional exposure on the short side. Other types of risk-neutral spreads include beta neutral for equities or duration neutral for bonds.

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Choosing a Spread Choosing a Spread


The idea behind choosing a spread is to start with a reason why the long side will outperform the short side. Traders can use various methods to select which spreads to trade. The method of selection will depend on the reason (or reasons) for suspected outperformance. The sections that follow describe some common reasons that lead a trader to believe one security will outperform another, along with methods to use to screen securities to determine whether they meet the criteria. Some of the reasons are mathematical or statistical in nature; as a result, the selection criteria are also mathematical and statistical. Other reasons are intuitive in nature, and the methods are less rigorous. Some traders use a combination of criteriasome mathematical and others intuitiveto arrive at a trading strategy. Regardless of the types of criteria you use, tools are available on the Web and through our free Spread Analyzer tool and our subscription-based SpreadTraderPro program. All of these tools can assist you in discovering and analyzing good trading candidates.

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Statistical Methods
Statistical-methods traders use mathematical approaches to first identify spreads that trade around a mean and then find opportunities to trade when these spreads have diverged from this historical mean. In these cases, traders must select spreads that are likely to revert to their historical means. Identifying these spreads involves statistical analysis. Below is a description of the theory behind statistical analysis. If you find some of the theory challenging or confusing, don t worry. Our tools do most of the hard work for you. Stock prices are typically modeled as Brownian motion (random walk), where the price in each period is a function of the price in the prior period, Y (t 1); the trend rate of increase, B; and an error term that has an expected value of 0: Y(t) = B + Y(t - 1) + e(t) Each leg of the spread can be modeled in this way. Figures 2 and 3 show the movement of several examples of pairs.
120 100 80 60 40 20 0 -20 120 100 80 60 40 20 0 -20

Figure 2. Pair 1

Figure 3. Pair 2

In both graphs, the two stocks diverge from each other at points and converge at other points. The goal of the statistical analysis is to determine whether it is likely that the two stocks will converge if they diverge.

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Cointegration is the metric we use to determine this likelihood. Cointegration is a


confidence level that when two securities (long and short) deviate in relative value, they will revert to the mean. We can think of cointegration as a metaphorical spring mean-reversion model. When the spring is stretched (Figure 4), it tends to pull back toward the middle (Figure 5). Similarly, when a mean-reverting spread deviates from the mean, a force pulls it back. As statistical arbitrage spread traders, we look for situations where the spring is stretched so we can enter the trade, profiting from the return to the mean level. We should not confuse this with correlation.

F = -kx Stock B

Stock A
Figure 4. Spring Mean-Reversion Model: Stretched

Stock B

Stock A
Figure 5. Spring Mean-Reversion Model: Reverting

Again, correlation is sometimes confused with cointegration; however, the statistical cointegration does not necessarily imply a high correlation. Correlation is a measure of how two securities move in relation to one another. A high correlation implies that
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the two stocks move in synchrony over the short term but does not guarantee that the two divergent stocks will revert to the mean in the long term. This distinction between correlation and cointegration was demonstrated by Dr. Ernest P. Chan.1 Robert F. Engle and Clive W. J. Granger proposed a two-step approach to calculating cointegration: If each individual stock price series exhibits a random walk (nonstationary) but a linear combination of them is stationary, then they are said to be cointegrated.2 Below we give the steps for calculating cointegration: First step: Determine the time frame you are going to use for the analysis (more on this later). You may want to look at a few different time frames, such as one year, two years, or five years. Perform ordinary least squares (OLS) regression on the chosen time series equation below to estimate the beta. In the equation, Y(t) is the price of one security at time t (dependent variable), and X(t) is the price of the other security at time t (independent variable). Once you know the beta, use the known values of Y(t) and X(t) to get the residuals (spreads).

Second step: Test the residuals for stationarity using the augmented Dickey-Fuller (ADF) unit root test.3 Mathematical programs such as MATLAB or R have functions to calculate the ADF test statistic. The ADF test looks at the following equation:

Ernest P. Chan, Cointegration Is Not the Same as Correlation, Trading Markets (blog), November 13, 2006, http://www.tradingmarkets.com/.site/stocks/commentary/quantitative_trading/ Cointegration-is-not-the-same-as-correlation.cfm. 2 Robert F. Engle and Clive W. J. Granger, Co-integration and Error Correction: Representation, Estimation, and Testing, Econometrica 55(2) (1987): 251-276. 3 Said E. Said and David A. Dickey, Testing for Unit Roots in Autoregressive Moving Average Models of Unknown Order, Biometrika 71 (1984): 599-607.

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The ADF looks at the mean reverting co-efficient, gamma. The test uses the null hypothesis, gamma equal to zero, and the alternative hypothesis, gamma less than zero. The result is a confidence level that we can reject the null hypothesis in favor of the alternative. If the alternative hypothesis, gamma is less than zero, is deemed appropriate, then the spread will tend to mean-revert because the change in the spread at any given point in time is a negative function of the level of the spread. Higher spreads will tend to decline and lower spreads will tend to increase. Individual traders must use their own judgment to determine what degree of confidence is required. Keep in mind that the higher you set the confidence interval, the fewer opportunities you will find. On the other hand, if you set the confidence interval too low, you increase the chances of finding spreads that are not really cointegrated. At Bigger Capital, we like the cointegration confidence interval to be at least 90% using a few different time frames. Once you identify a spread that is likely to revert to the mean, another critical piece of information is how long it will take to revert. A spread that you expect to revert in three days is a much more attractive investment relative to a spread that you expect to revert in three years. We can calculate the half-life, which is the time it takes for the spread to revert to half its initial deviation from the mean, to determine the holding period for a mean-reverting spread. To calculate the half-life, we first need an estimate of the rate of mean reversion. The rate of mean reversion is the slope of the line Y = (X), a linear regression using the daily change in the spread (current spread previous spread) as the dependent variable and the difference between the current spread and the mean (current spread mean of spread) as the independent variable. Once we estimate the rate of mean reversion (), we can calculate the half-life using the equation provided in Ornstein-Uhlenbecks mean-reverting equation4:

Ideally, spread traders would prefer to look at spreads with a low half-life, but again, traders should use their judgment and their capital costs to determine what is
4

Ornstein-Uhlenbeck Process, Wikipedia, last modified September 9, 2011, http://en.wikipedia.org/ wiki/Ornstein%E2%80%93Uhlenbeck_process.

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acceptable. At Bigger Capital, we prefer spreads with half-lives of fewer than 50 trading days. Once you have identified a spread that is cointegrated with a reasonably short halflife, you need to identify an entry point where the spread has deviated from the mean value. The z-score is a measure of how far a spread is above or below the historical mean.5 We express the z-score in units of standard deviation. Expressing the deviation in terms of units of standard deviation allows traders to compare one spread to another. Once again, individual traders must decide how many standard deviations away from the mean makes a spread rich or cheap. At Bigger Capital, we look for spreads that are at least two standard deviations from the mean. There are no clear-cut answers to these questions of judgment. One trader may tolerate a lower confidence level for cointegration in exchange for a higher absolute value z-score. Another may want both a high confidence level for cointegration and a high absolute value z-score but care little about half-life. As far as the period you should use to calculate the above statistical measurements, we suggest looking at multiple periods for all the measurements. You may choose to give more weight to recent data (which we do), but don t ignore the longer-term measurements. If a pair looks cointegrated for two years but not five years, you may want to look for something else to trade. If something looks cheap using one year of data but expensive using four years of data, you may want to reconsider. The following example will illustrate our point. First, we define our spread as 10 * NFX 17 * BRY. On February 16, 2011, this spread closed at about -68. Using two years of data, this spread was cointegrated with a confidence level of 95%, had a 20-day half-life, and had a z-score of -2.1. It looked like a buy.

Standard Score, Wikipedia, last modified June 30, 2011, http://en.wikipedia.org/wiki/ Standard_score.

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Figure 6. 10 * NFX - 17 * BRY Spread Using Two Years of Data However, when you looked at five years worth of data, the picture changed. The spread was no longer showing strong cointegration and had a z-score of 0.7, indicating that if anything, the spread was rich. See Figure 7.

Figure 7. 10 * NFX - 17 * BRY Spread Using Five Years of Data Sure enough, by the end of the next day, the spread closed at about -117. The following day, it lost another 27 points. See Figure 8.

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Figure 8. 10 * NFX - 17 * BRY on February 18, 2011 The following is a framework for how to look at statistical spreads based on the concepts we discussed above. 1. Choose a time period or periods. We prefer looking at multiple time periods, but some traders may want to focus on only the short term or only the long term. There is no clear-cut right or wrong answer. 2. Is the spread cointegrated for the time periods you selected? This requires selecting a confidence interval. We recommend at least 90%. 3. How far from the mean do you wish to enter into a trade? Two standard deviations is a common entry point for many traders. While this is not a hardand-fast rule, we have tested entry points ranging from 1 to 3 standard deviations. What we find is that entering at 1 standard deviation means the spread is likely (mathematically) to continue outside of the range, because only 68% of observations are within the range -1 to +1 standard deviations from the mean. If we use 3 standard deviations as the entry point, the mathematical probability of the spread continuing outside the range is low. However, we find that often a move to 3 standard deviations is indicative of a change in the underlying cointegration model, where the pair will not be cointegrated going forward.
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4. Choose an exit point and, if desired, a stop-loss point. The targets you set will depend on your holding period preferences. Obviously, the farther away you set your targets, the longer your holding period will be. We should note that your target point does not necessarily have to be the mean. It could be halfway to the mean, or you could target a percentage return. If you are unsure as to how far you should set your stop-loss in relation to your profit target, we recommend that they be symmetrical to the entry level. Once you analyze a lot of spreads, you will find that it is difficult to think of spreads on your own that are cointegrated with a high confidence level. SpreadTraderPro delivers a daily list of highly cointegrated spreads for various time periods to assist with this process. Members can sort their daily scan by the criteria they find the most useful. See Figure 9.

Figure 9. Daily Scan in SpreadTraderPro Our daily scan contains two additional columns that we need to define. The zero crossing rate is the number of times the spread crossed the zero value for the defined period. A higher number implies a shorter holding period and a greater mathematical probability that the spread will not continue to trend. The sum of least squares is the squared distance over the selected period. The lower this number, the tighter the spread, and the better the chance that the price of leg one will not wander far from the price of leg two.
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The SpreadTraderPro daily scan is the most efficient tool available for statistical spread discovery. If you are not a member of SpreadTraderPro, you can still use our free tool, Spread Analyzer, to analyze spreads that you either think of on your own or that you find through Twitter or other sources. The input screen for Spread Analyzer often contains interesting, relevant spreads. See Figure 10.

Figure 10. Spread Analyzer in SpreadTraderPro

For more information on statistical methods, please see the following video: Heat Map.

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Non-Statistical Methods
Many non-statistical spread-trading strategies are less rigorous in their criteria. Trading in-play stocks, momentum, earnings, and value are all examples of nonstatistical strategies. A good source of information for these types of spreads is our Ranked Spreads database for SpreadTraderPro members. The Ranked Spreads database can show you great spread pairs for a given stock that you are looking to trade. See Figure 11.

Figure 11. Ranked Spreads Database

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1. Trading on Bottom-Up and Top-Down Analysis (Value Investing)


You can choose the long and short sides of a spread by using fundamental valuation methods. In applying this strategy, which we usually refer to as long/short, investors or traders do not look at historical prices. Instead, they choose their view based either on the underlying fundamentals of the two securities chosen, which we call bottomup analysis, or on macro views about certain industries, sectors, or geographical regions, which we call top-down analysis. Here, you can employ many different methods and trading styles. The trick is to develop a theory (or multiple theories) as to why one security will outperform the other. Traders do not have to limit themselves to comparing one company against another. For example, they can bet the performance of one company against the performance of a sector using a sector ETF. Alternatively, they can bet the performance of one countrys markets against another countrys markets using market ETFs. Or, they can bet one sector against another sector. The possibilities are endless. The point is to start with a reason why one security will outperform another over a given period. How to find bottom-up and top-down spreads One method is to find a stock that is trading cheap based on a fundamental measure, such as P/E, or a combination of measures. A simple stock screener such as Google Finance, Finviz, Value Line, or Magic Formula Investing can help you find a stock that meets your requirements. This is your long (or a short). Then you look for a hedge, such as a competitor company that looks rich by the same metrics. You can also use an ETF for the sector or even the broad market. You can use our Scan All tool to find cointegrated spreads that contain your long (or short) stock. The idea is to find an effective hedge for the position you want to initiate.

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2. Merger Arbitrage
When a merger is pending and the consideration is equity in the acquiring company, shares in the target company typically move in tandem with shares in the acquirer. The likelihood of completion of the merger will dictate the strength of the relationship. If a merger is considered highly likely to complete, then the spread (Target * Ratio Acquirer) will be trading close to zero. When a merger is considered less likely to complete, the spread will trade at a discount. In these cases, if the merger does complete, the spread trader who bought the spread (Target * Ratio Acquirer) will make a profit. If the deal falls through, the trader who shorted the spread will make money. For example, on April 11, 2011, Level 3 Communications, Inc. (LVLT) announced its intention to acquire Global Crossing (GLBC). Each shareholder in GLBC would get 16 shares of LVLT. If the merger were 100% certain to complete, the spread should trade at zero. As you can see from Figure 12, the spread trades below zero but increases toward zero as the probability of completion increases:

Spread GLBC - 16*LVLT


0 -1

-2
-3 -4 -5 -6 -7

-8
-9 -10 4/1/2011 5/1/2011 6/1/2011 7/1/2011 8/1/2011 9/1/2011

Figure 12. Spread Increases with Probability of Completion If you had bought the spread in April at -2, you could sell it in September for close to zero. The risk is that the merger does not complete, in which case the spread would likely fall back below -8.
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a) How to find merger arbitrage spreads


Traders can find merger arbitrage spreads by searching news articles on the Internet or setting alerts that notify them when a merger is announced. Merger arbitrage is a popular spread-trading strategy, so in many cases there will be articles discussing the spread. When you trade these types of spreads, it is important to be aware of important dates for announcements of key rulings and regulatory issues because these can be catalysts for big moves in the spread.

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3. Liquidity Gap Spreads


Securities often experience liquidity gaps. Liquidity gaps occur when a security experiences a sharp movement over a short time frame. The definition of what constitutes a sharp move depends on the spread involved. A trader might want to exploit this situation by trading in this security and hedging it with another instrument, expecting mean reversion between the two securities. Liquidity gaps are more frequent after market hours or when an institution announces a material piece of information, such as a secondary public offering (SPO), an acquisition, earnings, or any material news related to the performance of the company.

a) How to find liquidity gap spreads


Locating liquidity gaps requires screening for intraday price changes. You must be able to do this in real time so you can react quickly to provide liquidity. Interactive Brokers has screeners you can use to sort by biggest daily percentage changes (positive or negative). Make sure your screener gets real-time data for normal hours and pre- and post-market hours. Once you have located a liquidity gap, you need a hedge. This can be a competitor, a sector ETF, or a broad market index. You can also use our Scan All tool to find spreads containing the stock that is gapping.

b) Trading liquidity gap spreads example


It is typical for some spreads to move a lot, while others don t move much at all. Because the SPY-IWM spread matches one broad market index versus another broad market index, we believe that even a half percent move over an hour or two is a move worth tradingespecially if it is not set off by a specific news item . Often, this spread reacts to the degree of risk market participants are adding or taking out of the market. When they are taking risk out of the market, the spread increases in value, and vice versa. We like to trade this spread because our indicators are good at judging whether the move is a liquidity gap or a risk premium adjustment.
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We traded in and out of SPY IWM for a half percent or more gain intraday three times in the prior two weeks (read this post describing one of those trades). We sold the spread a fourth time late that Friday. See Figure 13.

Figure 13. SPY IWM Trade

c) Big expiration
When the U.S. market is facing a significant options and futures expiration around the third Friday of the month, the market experiences large swings as you approach the expiration of the derivatives market. Spread traders can take advantage of these setups. Triple witching is usually a fertile ground for opportunities.

d) Program trading
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Program trading can create sharp liquidity gaps, especially when the robots go mad. Fast traders can take advantage of these situations if they are good at recognizing what is going on in a timely manner.

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4. Trading the News a) Lvy flights: How to think about the news
Seth Godin wrote a fabulous blog post6 about a cool mathematical concept called the Lvy flight that shows up in nature.7 It also shows up in finance. For example, a journalist finds an interesting story to write about. Think about Merck and Vioxx.

Figure 14. An Example of Lvy Flight (Source: Wikipedia) That was big business news, and it stirred up emotions. Many people took a stance on both sides of the issues related to this event. Writing about Vioxx generated good readership and sold advertising. Thats the goal of the media, right? Eventually, readers got bored with the story and moved on. Our journalist had to find other news to generate traffic. The journalists path to different food sources followed a Lvy flight from one random walk to a cluster followed by the same process over and over again, as depicted in the image.
6

Seth Godin, The Levy Flight, Seth Godin (blog), April 8, 2010, http://sethgodin.typepad.com/ seths_blog/2010/04/the-levy-flight.html. 7 Lvy Flight, Wikipedia. Wikipedia, last modified September 9, 2011, http://en.wikipedia.org/ wiki/Ornstein%E2%80%93Uhlenbeck_process.

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Or you can think about it this way: the path between each cluster is a stochastic directional vector, and the cluster is a manifestation of the cockroach theory. This theory states that if you find a roach in the cupboard, more than one roach is usually crawling in the same location. Using Godins example, once an animal finds food along its random walk, the animal will rummage in the same area because the likelihood of finding more food is elevated. You must think this concept is crazy, right? Here is another example of the same phenomenon. A few years ago, Twitter user @ashrust led me to the article Sharks Hunting Strategies More Like Physics Than Biology written by Brandon Keim, which considers Levy flight principles. Keim s article opens up another rich vein ripe for financial exploration: how sharks respond to the supply of food could have interesting implications for finance. Enough about animals: lets get back to humans. As traders, our food is stock prices discrepancies. For trading success, it is essential to understand what causes the price discrepancies in the marketplace. News and other phenomena, such as the mood of market participants, for example, influence stock prices on a daily basis. For this chapter, we will focus on news. Ryan Holiday wrote a great book about the media business titled Trust Me, Im Lying: Confessions of a Media Manipulator. Holiday describes how blogs control and distort the news. This book is a must-read as it will make you aware of what goes on in spin media, and it will help you understand the nature of the Levy flight. By understanding the dynamics going on during a Levy flight, a trader is in a better position to take advantage of the situation to his own advantage, especially when the media stirs up emotions to extreme levels. Heck, at times journalists and financial bloggers alike fabricate situations that do not exist just to generate traffic. They create food where none exists and distort market

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prices in the process. It is our role as traders to understand these dynamics and to implement trading strategies to take advantage of these situations. Here is a sample of questions you can ask yourself to understand the impact of the news on the securities that you have identified as being in play:
1. 2. 3. 4. 5. 6. 7. 8.

What is the relationship between the news, the volatility, and spread values? How long will it take the media to migrate from this story to the next? When do you expect the pressure to abate? When the pressure does abate, do you think the spread will revert to the mean? Can you identify a similar situation in the past that you can use as a proxy to model how this situation will behave? What is the reaction of traders and investors? If they amplify the news, will the situation stabilize once they get bored and move on to another story? Can you find other candidates that could be influenced by this situation that have sold off and are punished unduly (Cockroach theory)? Which type of trade do you implement to exploit this situation?

When the next Vioxx crisis erupts, I will remember that the media will eventually walk away and let it go. The news will subside, as it always does. As Benjamin Graham once said, This too shall pass. Since I wrote the original post, weve used this mental model to sell volatility on Goldman Sachs when the fraud scandal erupted in April 2010. You can read more about it here: Levy flight, Truffle Diggers, and Goldman Sachs. The trade was highly profitable, and we unwound this trade in early July 2010 after the truffle diggers got bored and moved on to another story. The Gulf of Mexico became a much more powerful story to coverthen the North African crisis, the Japan crisis, and so forth.

b) Trading the cockroach theory


Here is how we applied the cockroach theory to the trading of Select Comfort Corporation (SCSS) and Tempur-Pedic International (TPX). On Thursday, April 7, 2011, after the market close, TPX said it expected to report strong first-quarter results and increased its full-year guidance. In the past two
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reporting periods, TPX announced earnings prior to SCSS. In each case, a solid earnings report from TPX was followed by a solid earnings report from SCSS. We took TPXs announcement as a strong indicator that SCSS would also report robust results in late April. The 5 * SCSS 1 * TPX spread had been trading around $10 since the prior quarters results. It closed at $10.76 on April 7, so when it dipped below $8 in after-hours trading, we bought it. We bought some more on the morning of April 8, also slightly below $8. As it turned out, we could have waited a little longer because the spread at one point dipped below $5 and closed Friday at about $5.60. Nevertheless, based on the cockroach theory, we were confident it would return to the $10+ level. On Thursday, April 21, we provided the following update to our SCSS TPX trades on April 7 and April 8. On both dates, we bought five SCSS and sold one TPX on the back of a rally in TPX after the firm said it expected strong first-quarter results. In the prior two reporting periods, SCSSs results mimicked TPXs results, and we were betting the same would happen this time. Sure enough, SCSS significantly beat expectations when it reported earnings. The stock went up 28%. We unwound the spread the day after the report for an approximate 13% return. This is how the cockroach theory can help you identify juicy situations. A good way to find candidates for the cockroach theory is to look for big daily moves in stocks. When you see one stock move higher (lower) due to earnings, think about other similar companies that might also report good (bad) earnings. If one stock is the target of an acquisition, look for competitors who might also be potential targets. For a hedge, use the company with the original price move (in our example above, TPX). You can also use a sector ETF or the broad market.

c) Trading crisis-related spreads


Spread traders should always be alert to crises, which present significant opportunities. As an example, the triple whammy earthquake tsunaminuclear event in Japan in early 2011 presented a great opportunity, as the Nikkei collapsed 20% while the S&P 500 dove 6%. There were plenty of opportunities to trade spreads in both markets and make a good chop.
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During that episode, you could also have traded the relationship between gold ETF and the miners. As Warren Buffett says, Be fearful when others are greedy and greedy when others are fearful.
i.

How to find crisis-related spreads

Go where the crisis is, young man! Typically, a crisis is easy to find. It is top news on every TV channel and news site on the Internet. The hardest part is buying in this case. Buffetts quote should inspire you to buy when others are selling in crises. The buy side of the spread is always the target of the crisis, whether it is Japan (EWJ), nuclear stocks, Steve Jobss resignation as CEO of Apple, or even U.S. indices. The hedge side of the spread can be a sector ETF or another broad market index.

d) Trading event-related spreads


When a stock experiences a big move due to news such as an earnings announcement, trading spreads means you can trade the move in stock price while reducing or eliminating market or sector risk. Depending on your view, you can either buy or sell on the news. For example, on March 25, 2011, Accenture (ACN) reported good earnings. The spread 5 * ACN 2 * SPY had closed at -1.8 the previous day and was trading as high as +21.15 pre-market. After the open, it traded down to +11 by 10:30 a.m. and closed the day at +8.85. The market reacts differently to big events at different times. Making money with this method requires traders to be in tune with these reactions.
i.

How to find event-related spreads

Some events are known in advance (e.g., earnings announcements). You can get a calendar of upcoming earnings announcements from CNBC or from Yahoo! Finance. The site Finviz allows you to screen for stocks reporting earnings in any number of
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time frames, including today, after the close, and tomorrow before the open. You can research the stocks in advance so you know what earnings number is expected. If there is a surprise and a big move when the event occurs, you can trade the spread using a competitor, sector ETF, or the broad market as a hedge.
ii.

Trading a positive catalyst event

Here is an example of how you can trade the positive news about a company. We traded this spread at the end of June 2012. With the introduction of its Nexus tablets and its glasses, Google (GOOG) will have an abundance of fresh news in the next few months, which will create trading opportunities. This situation is appealing to us because the stock is statistically cheap against the Technology Select SPDR (XLK), as you can see on the Spread Analyzer image displayed below. GOOG is also cheap against Intel (INTC) and the triple Qs (QQQ), but we like the $spread better against the XLK given the volatility of the spread. This vehicle will move quite a bit on fresh news and traders can take advantage of this by leaning on GOOGs cheapness. You can look at the $spread within the analyzer here for more clarity. You can play around with the time frame or run GOOG against any others stocks of your choosing. At the time of this writing (9/4/2012), we are long GOOG against INTC, QQQ, and XLK.

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Figure 15. GOOG XLK Spread

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e) How I exploited a Lvy flight with spreads


Lvy flight situations are easy to find. When the media is all wrapped up in stirring up emotions and a stock price is moving wildly as a consequence, you know that the story is a Lvy flight. Examples of this are BP and the Gulf Crisis, Goldman and the fraud scandal, and so forth. Ideally, a stock should have moved 20% or more (most of the best opportunities happen when the news is negative and the stock moves down sharply).

Figure 16. COH After Earnings Release in August 2012 For example, in early August 2012, Coach (COH) reported earnings, and the stock gapped down more than 20% on the news. When a situation like this arises, the first thing I look for is potential pairs using our Scan All feature.

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Figure 17. Potential Pairs for COH

I decided to investigate the XLY COH spread further, since I had already rated this one in the past and was familiar with it. I had been monitoring it for quite some time. For my style of trading, I did not want to enter the trade right away while the news was still fresh. Often, big gaps down like these will be followed by more weakness. I wanted to buy COH and sell XLY beta neutral on some strength.

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Figure 18. XLY COH Spread The spread spiked to 90.09 on that day. I set an outbound alert at 75 thinking that once the spread reached this level, it would probably continue lower on momentum.

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Figure 19. Setting Alert on XLY COH On August 3, the system alerted me that the spread had reached the set level, so I sold the spread at 74.81. On August 8, I bought back the spread at 46.07 for a profit of almost $30 per spread. It was a great situation.

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Figure 20. Results of Spread Trade, XLY COH


a. How Jennifer Galperin exploited the same situation on a much shorter time scale

Here is a video about how Jennifer Galperin traded COH earnings on the same day. She chose a different spread, and she talks about this in her video, which you can find here: COH Earnings Daytrade.

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5. Day Trading Spreads


Traders should look for stocks with recent or anticipated news. Typically, these stocks are called in play and will move at least 5 to 10% (either up or down) on the news; anything less than that is just volatility. You then develop a viewpoint on whether the spread will continue in the direction of the gap or reverse in the opposite direction. Your viewpoint can be based on the patterns of similar in-play stocks: for example, stocks that beat earnings typically behave one way, and stocks upgraded by analysts behave another way. Your viewpoint can be based on technical indicators that are bullish or bearish, or it can be fundamental: for example, based on your research, you feel the news should have more (or less) of an impact on the price of the stock. As an example, on April 14, 2011, Supervalu (SVU) reported earnings and was trading higher. We were bullish on the stock for fundamental reasons. We decided to use the spread 15 * SVU SPY (using the broad market as a hedge). We bought the spread in the morning at $22 and sold the spread in the afternoon at $27.4. The next day, the spread traded back down to $22, and we bought it again, selling it in the afternoon for $29. Over the next few days, we were able to trade in and out of the spread, buying on intraday dips and selling at higher levels during the same day or the next day.

a) How to find intraday spreads


It is possible to day trade any spread, just as you would day trade stocks. Typically, you want to find a spread that you think will move significantly during the day so that you can make sufficient profit to cover your trading costs. For this reason, you typically want to look at stocks that are in play with either recent or anticipated news. Stocks with fresh earnings news are a good place to start because this type of news is anticipated in advance. Other news to trade on can be same-store sales data for retail stocks, big contracts awarded or lost, analyst upgrades or downgrades, mergers and acquisitions (M&A) activity, or management changes. Once you select an in-play stock, you then choose a hedge, which can be a competitor, a sector ETF, or a broad market index. Ideally, to how each company is affected by the news (weather events or changes in regulatory environment make

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sense for that type of viewpoint). Use our Scan All feature to find spreads that contain your in-play stock.

b) A word about day trading and risk management


Many day traders do not use spreads. They view intraday risks as minimal, and they need to act fast. In a bull market, this strategy can work well. But in times of crisis, we are reminded of the most important rule of risk management: dont lose money. When we see big intraday moves down in the markets, correlation among stocks increases dramatically. If you buy ABC stock on good earnings news, only to see the market down 5% on the day, chances are you will lose money. If you buy the spread ABC SPY, you may come out on top. Knowing this will allow you to sleep at night and keep your capital intact.

c) Intraday spread trading example


Check out the trade we did at 8:30 a.m. on September 2, 2011 as the employment data news hit the tape. We bought the spread 8 * $SPY 13 * IWM at a level of $33.94, which was about $10 below the level it was trading just before the release: we are talking about a fraction of a second. Our ability to make money in this situation depended on the following three components: 1. Major news that can move the market big time. 2. Fast technology to capture a short-term liquidity gap that was almost invisible to the naked eye. Fast computers are great. Embrace them. 3. The appropriate low delta spread. You wouldnt want to trade this with an open delta. We wish we could have done more of this trade, but it just happened too fast.

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Figure 21. Summary of Trades on September 2, 2011

Figure 22. Spread Activity on September 12, 2011

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6. Dual-Class Shares
Companies with dual-class shares can present an opportunity for spread traders. See Dual-Class Share: A First-Class Strategy for information on this strategy.8

Paul H. Schultz and Sophia Shive, Mispricing of Dual-Class Shares: Profit Opportunities, Arbitrage, and Trading, Turnkey Analyst (blog), March 26, 2011, http://turnkeyanalyst.com/2011/03/dualclass-shares-a-first-class-strategy/.

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7. Patterns
By taking the market out of the equation when looking at the relative pricing of two securities, you will be in a better position to identify patterns at different time scales and trade around them. Look for patterns related to volume, percentage moves, or anything else you can think of. Start your search for profitable patterns by following your favorite spreads (just a few to keep the task manageable) on a daily basis and pay attention to what is going with them at different time scales, especially intraday. To start, you may want to look for spreads between ETFs that track important economic indicators, such as SPDR S&P 500 ETF Trust (SPY), iShares Barclays 20+ Year Treasury Bond (TLT), iShares Russell 2000 Index (IWM), SPDR Dow Jones Industrial Average (DIA), SPDR Gold Trust (GLD), and others.

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Combining Different Methods Combining Different Methods


Of course, traders can always combine different methods when spread trading. They can start with a fundamental view about two different securities and use statistical techniques to choose entry and exit points. They can use statistical techniques to find pairs and then either select or eliminate pairs based on some fundamental or macro view. Or, traders can give equal weight to both methods, selecting pairs that meet a strict set of criteria based on fundamental and statistical tests. Another strategy might be to locate candidates that have events coming up and find a hedge using statistical methods. You should experiment with different combinations of strategies, because combining two different methods can dramatically improve the profitability of your trading strategy. Please watch our webinar for more about this: My Little Tricks Webinar. Sometimes, one spread trade might lead to another spread trade. For example, you may trade one spread in response to an event catalyst and find a competitor to trade as a cockroach theory trade. Or maybe you successfully locate one statistical spread and you decide to further investigate spreads in the same industry. Once you start thinking like a spread trader, you will find endless possibilities.

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Execution: Choosing Entry Price, Size, and Time Execution: Choosing Entry Price, Size, and Time, \\try Price, , and Time
Choosing entry price, size, and time depends on a number of factors. Some of these factors are going to be highly specific to each individual trader (such as total capital and risk appetite). Other factors will apply generally, such as liquidity and volatility of the underlying securities. For the most part, though, strategy type often dictates price and time. If your strategy is based on statistical methods, your entry price and time will for the most part be determined by how far from the mean the spread has diverged. If it has diverged past a pre-specified amount, you put the trade on. You can adjust the size based on how far something has diverged from the mean and how strong the cointegration is. Also, it is preferable to do many small trades when using statistical methods because you may lose money on some spreads, but you will make more money on your winners. For trades where there is an event (earnings or other expected news), your entry time and, to some extent, price are determined by the event. For example, in the SCSS TPX spread, the entry event was TPX earnings, and the exit event was SCSS earnings. Entry and exit points can also be driven by gap moves in the spread. For example, one morning several months ago, shortly after the open, the spread 4 * GLD 9 * GDX was trading at +1.5. By late afternoon, the spread was trading about -3.5. We had a bid in at -5 for the spread but decided to move the bid up. The $5 downward move was too big to ignore. Trading volume for both ETFs, while large compared to most stocks, was only about 70% of normal for GDX and 50% of normal for GLD. Thats probably enough to cause this type of move. Whatever the reason, it was really just noise. And it was an opportunity to exploit. We got long again at -3.3, and by the end of the day, the spread moved up to -0.37. Monday morning, 15 minutes after the open, we unwound the GLD GDX we had bought late Thursday for an $8.5 gain per spread.
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Execution Technology Execution Technology


By technology, we mean the tools you use to evaluate, track, and trade spreads. Lets start with your brokerage firm. Aside from the typical attributes one looks for in a brokerage firm, such as low trading cost, reliable and fast execution, good capitalization, and the like, it is great to find one with spread execution capabilities. At Bigger Capital, we trade via Interactive Brokers (IB). IB offers spread execution, which means all you have to do is define a spread and enter a price level you want to trade. IBs software executes both legs simultaneously. Here is a screencast that shows you how to define a spread in IB. However, most online brokers do not offer this feature, which means you have to leg into the spread. The trader should take this additional element of risk into account, especially when the spread consists of illiquid stocks. When choosing an online broker, you might want to use the guidelines listed below. After you have chosen a broker, it becomes hard to switch, especially if youve developed software running on a brokers platform. Save yourself some headaches by making the right decision up front. Here are the attributes you should look for in an online broker: Low trading cost Powerful and reliable technology Comprehensive sandbox, otherwise known as paper trading or demo accounts, for experimenting with your strategy; see more about this subject here: Cool Financial Tools

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Extensive and cutting-edge application programming interface (API) technologies; for traders with little or no programming experience, we recommend going with a broker that offers a simple DDE for Excel platform, as Excel offers a familiar and user-friendly interface Breadth of products in both type (stocks, bonds, futures, commodities, currencies, options, etc.) and geography (global) Powerful algorithms you can use to make money right out of the gate Continuing education via webinars Strong credit and well capitalized Reliable and fast mobile platform Portfolio margin capability; margin based on risk, not regulation T Once you have selected your broker, you will probably want to keep track of the great spreads youve found. You may even want to be alerted when these spreads get to levels where you want to enter or exit a position. The best software we have found for this type of tracking is SpreadTraderPro. Our augmented Spread Analyzer features allow you to keep track of past queries, rank spreads based on certain criteria, and set alerts for when spreads reach desired levels. Plus, you can enter your trades and a separate tab will calculate your P&L by spread position each day, month, and year.

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Risk Management
Risk Management
The key spread-trading risks to pay attention to are the following:

Unlimited risk on short side Correlation risk Cointegration risk Concentration risk M&A risk Short squeeze risk Opportunity cost risk Specific risk Market risk Political risk Execution risk (if legging into spread) The unexpected Adverse momentum

The spread-trading business is statistical, which means high volume and small size. There are diseconomies of scale in financial markets. Diseconomies of scale means as you increase the size of your position, the expected P&L declines. Spread traders are exposed to the short leg, and that is one of the reasons spread traders should keep their positions small relative to the size of the portfolio. Start small! Example: The Gold Spread Moves Sharply Against Us (5-15-2011) The spread that occupied most of our attention this week was $GLD-$GDX, and we didnt even trade it this week. We have been short $GLD-$GDX since late April, and the spread recently moved sharply against us. The spread is
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currently trading at its highest level since late 2008. Of course, its always a good idea to re-evaluate a position that has made such a large move. Weve decided to leave it on for now because we dont believe there has been any fundamental change in market conditions to justify the current level. We feel the move is attributable to the recent sell off in silver (and other commodities). We think this sell off spooked some holders of $GDX even though gold itself has held up rather well compared to other commodities. Also, our position is relatively small compared to the size of our portfolio. We try not to have many positions that are so big that we can t take a little pain once in a while. Table 1 shows some of the risk you have with the corresponding pairs structure:

Table 1. Risks with Pairs Structure


Leg 1 Stock A Stock A Stock A Leg 2 Stock A Stock B Stock B Sector/Industry Same Same Different Risk No risk Specific, cointegration, short Specific, cointegration, industry, short Specific, basis risk, short Specific, short, industry

Index A Broad Market

Stock B Stock B

Same Different

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Exit Price Exit Price


Like entry price, exit price can be driven by factors highly specific to each individual trader, such as total capital and risk appetite. It can also depend on liquidity as well as on the method chosen to enter the trade. If you use statistical methods, then you have a measurement of what the correct price of the spread is. Factor this into the decision of when to unwind. Other factors would be total return earned, size of position, and time holding the position. An example will help illustrate this point. Suppose that using statistical methods, we purchase a spread trading 3.5 standard deviations below the mean with a half-life of nine days. Now lets suppose that within a few days, that spread moves in our favor to 2.5 standard deviations below the mean. Weve made a nice profit (unrealized), but the spread is still cheap, so were hesitant to unwind it. So what we might do is unwind part of it to lock in some profits but hold on to some too in the hopes of realizing more profit. Now lets suppose it took 35 days for that same spread to make that same price move. In this instance, we might be more inclined to unwind the whole thing, because in moving this slowly, the spread wouldnt be behaving as the statistics suggested it would. There isnt always a clear-cut answer as to when to exit a spread. The above example was meant to give you an idea of the types of factors to consider. You can use the Spread Analyzer to set alerts for when your positions hit an exit level. When the alert triggers, all you need to do is enter the closing order in your trading station.
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Figure 23. Alerts in Spread Analyzer

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Special Topics Special Topics


What Else Can We Trade Against This?
Sometimes you have a particular spread trade in mind, and you cant do it for a variety of reasons: for example, you already have too much exposure to one of the stocks in the pair, you cant get a borrow on the short side, or one of the stocks in the pair isn t liquid enough. When this happens, it is time to look for a substitute. Once we were looking to buy United States Oil Fund (USO) and sell SPDR S&P Oil & Gas Exploration & Production ETF (XOP). In one of our accounts, we couldnt get a borrow on XOP, so we substituted Energy Select Sector SPDR (XLE). We like XOP better because XLE is heavily weighted toward the major integrated oil companies, while XOP offers a broader-based portfolio. But XLE is good enough. As a matter of fact, when we originally decided to trade the oil vs. oil companies spread last year, we did our first trade with XLE but later decided that XOP was the better ETF for our purposes. So if for some reason you cant trade one side of a pair, look for a substitute. You may even find a more suitable security.

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How to Use a Spread to Form a Directional Opinion


At Bigger Capital, we like to trade the $SPY $IWM spread. In addition to being a great spread to trade for profit, this spread measures to a certain degree the amount of risk being added to or taken out of the market. The spread movement indicates the state of the money flow between small cap and large cap stocks. The behavior of the spread has been particularly interesting in September, 2012. This is what we have noticed, and this is how we have used our own interpretation to trade the market: The spread has increased in value overall throughout the month, indicating risk being taken out of the system (trend line).

Despite the increase in the value of the spread, $SPY rallied last week. We took this opportunity to initiate a short position. Notice the sharp spike up in the spread on September 2, followed by a sharp drop in $SPY on September 3. On September 22, the spread had a strong move downward, indicating that someone might be willing to take more risk out there (could be an aberration). On September 22, we traded from a long bias in the afternoon and made good money on that basis. Could the spike indicate a rally ahead? Maybe or maybe not, but we are looking to short the market aggressively if the spread spikes back up. If the spread continues declining and the spread holds its own, we will be active from a long perspective (small size) with a short-term horizon (a few hours).

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Figure 24. $SPY $IWM Spread

Figure 25. 1-Month SPY Chart Does this sound like a good game plan?

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Creating Signals
In the prior chapter, we explored using spreads to form a directional opinion. If you find a spread that has predictive values, you can use the spread or a weighted basket of spreads to create your own proprietary buy or sell signal. You can create signals by using a few spreads that you think have predictive value and assign a weight to each spreads daily percentage sign to create your own predictive index. Over the last few years, we have discovered a number of spreads with predictive value. We have called these spreads predictive because they are cyclical in nature. They can go to an extreme level, but, over time, they will revert to the mean.

Market Versus Predictive Spread 1


We use this spread to gauge risk aversion and risk appetite. When capital is flowing into large caps more than small caps, we can say that the market is risk averse. Alternatively, when capital outflow in large caps is less than small caps, we can also say this is a form of risk aversion. Figure 26 shows Spread 1 (blue, left vertical axis) compared to the S&P 500.

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1600 1400 1200 1000 800

120 100 80 60 40 20

600 400 200 0 8/31/2010

0 -20 -40 -60 8/31/2012

2/28/2011

8/31/2011 S&P 500 Spread 1

2/29/2012

Figure 26. Spread 1 Versus S&P 500 As Figure 26 shows, when the spread increases in value, the S&P 500 declines; conversely, when the spread declines, the S&P 500 rallies.

Volatility Spread 2
We use this spread to forecast the incoming volatility in the marketplace. As Figure 27 shows, when our volatility spread increases, the range of the volatility in the market dramatically increases.

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1600 1400 1200 1000

0 -5 -10 -15 -20

800
600 400 200 0 8/31/2010 2/28/2011 S&P500 8/31/2011 2/29/2012

-25
-30 -35 8/31/2012

Volatility ETF Spread

Figure 27. Relationship Between Volatility Spread and Range of Volatility in the Market Both short-term VIX tracker VXX and medium-term VIX suffer from contango. We recommend that you visit the topic about contango and backwardation in a later section.

Consumer Sentiment Spread


We use this spread to forecast consumer sentiment. When market participants anticipate strong consumer confidence, which leads to economic growth, they are more likely to push the S&P 500 higher. When the opposite happens, the S&P 500 is trending lower.

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1600 1400 1200 1000 800 600 400 200 0 8/27/2010

3 2 1 0 -1

-2
-3 8/27/2012

2/27/2011 S&P500

8/27/2011

2/27/2012

Consumer Confidence Spread

Figure 28. Consumer Confidence Spread vs. S&P 500

Interest Rate Spread


Similar to the market versus the predictive spread, Bachelier, LLC uses this spread to measure risk aversion and risk appetite rotation. For some reason, bonds are attractive investments to market participants during a period of market turbulence. Great value investors such as Warren Buffett and Benjamin Graham actually do the opposite. They invest in bonds when market is overvalued and sell them to invest in equities during a period of market turbulence. That topic is outside the scope of this book. In the early summer of 2011, our interest rate spread dip indicated a potential dip in the SPY. The SPY sold off hard in August 2011.

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1600 1400 1200 1000 800 600

200 150 100 50 0 -50 -100

400 200 0 8/31/2010


2/28/2011 S&P500 8/31/2011 2/29/2012

-150 -200 -250 8/31/2012

Interest Rate Spread

Figure 29. Interest Rate Spread vs. S&P 500

Gold Spread
This is one of the most interesting spreads we have come across at Bachelier LLC. It measures the flow of capital from equities to gold. Historically speaking, gold is considered to be the most pure, safe, and secure form of storing wealth, as it protects capital against inflation and market volatility. Over the last two years, gold has continued to underperform SPY. During every dip in the market in 2011 and 2010, people have bought gold. Therefore, its no surprise that the S&P 500 reached a new 52-week high this year not seen since the violent crash in 2008. Despite the fact that gold lags the equities market, one can look at the daily changes in the spread to measure the short-term market sentiment. See Figure 30.

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1600 1400 1200 1000 800 600

0 -100 -200 -300 -400

400 200 0 8/31/2010


2/28/2011 8/31/2011 S&P500 Gold Spread 2/29/2012

-500 -600 8/31/2012

Figure 30. Gold Spread vs. S&P 500

Creating Your Signal


This is the main subject of this section: creating a real-time signal that gauges market sentiment. One can create a simple but powerful real-time trading sentiment by measuring the real-time changes of these predictive spreads. In Table 2, we measure the real-time changes in every spread, which we record in the column Spread Today. We then compare these changes to the latest Spread Yesterday. For example, our predictive spread yesterday was 90, and the spread today is 70. The spread went lower. We gave that a score of 1.0.
Table 2. Real-Time Changes in Spread Spread Value T1 Value T2 Sentiment Weight Score Note Spread 1 70.0 90.0 1.0 0.5 0.5 Spread 2 0.5 1.0 1.0 0.2 0.2 Spread 3 100.0 90.0 1.0 0.2 0.2 Spread 4 -250.0 -300.0 0.0 0.1 0.0

Scoring: Our scoring is 1 for risk appetite, 0 for flat when the spread is unchanged, and -1 for risk aversion. Now the interesting bit is that we have four spreads in the spreadsheet. Similar to Spread 1, each spread will have a score of 1, 0, or -1 depending on the market
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sentiment. We have assigned each spread a weight as follows: Spread 1, 0.5; Spread 2, 0.2; Spread 3, 0.2; and Spread 4, 0.1. Add these together, and we get 1.0. We then multiplied the weight to the score of every spread. The result is the overall market sentiment. If you have created such a signal and it contradicts another predictive spread that you are following, there could be an opportunity to trade this spread, expecting that it will get back in line with the signal. We will rank many ETF spreads that have some degree of predictive power. SpreadTraderPro members who rank spreads have access to this treasure trove of information.

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Trading Statistical Spreads Around Earnings Dates


When trading spreads based on statistical analysis, it is important to be aware of any upcoming earnings or news events (including M&A activity). Strong catalysts like these can cause big moves in spreads. Sometimes a spread can look like it is far enough from the mean spread level to be an attractive entry point because of rumors circulating in the market. But when the news hits, the stock can move away from the mean so far that the statistical relationship breaks down. If this happens, your trade will lose money. In general, the goal of statistical spread trading is to find relationships that are likely to continue in the future. With big news catalysts, the future is difficult to forecast. At Bigger Capital, we try to avoid trading statistical spreads where one or both of the stocks are scheduled to report earnings in the next few days or where a merger is rumored or pending. Occasionally, we have situations where there is unexpected news on a stock. But, in general, our view is that if you know about a potential catalyst, steer clear of the statistical spread.

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Dividends
Dont forget to factor in dividends when calculating the price of a spread on the day that one of the stocks trades ex-dividend. This is best illustrated with an example. Suppose you are long one share of Stock A at $55 and short one share of Stock B at $50. In other words, you paid $5 for the spread. Suppose Stock B pays a $1 dividend, and on the ex-date, the price of Stock B drops to $49. Dont rush to unwind the spread because you think you just made $1. Dont forget that you owe a $1 dividend on the stock you borrowed. Keep this in mind for statistical analysis as well. Some data sources will adjust for dividends and stock splits, and others leave that up to you. It is important to know what your data source does in these cases.

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Carry Costs
In calculating the profit and loss of a spread trade, dont forget to take into account carry costs. You will pay interest on your long position and collect interest on your short position. The rate you pay on your long position will be higher than the rate you receive on your short position. For short-term positions, the carry cost wont have a significant impact, but if you hold long-term positions, you need to take carry costs into account. This may also affect your choice of spreads (targeting a shorter half-life when carry costs are high) or your entry/exit decisions.

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Contango/Backwardation
Contango refers to the situation in which the price of a longer-dated futures contract
is more expensive than the price of a shorter-dated futures contract. This is usually the case for nonperishable commodities. For example, the United States Oil Fund (USO) tracks oil prices by buying oil futures. Because the fund does not wish to take delivery of the oil near expiry, it rolls the futures contract forward to the next month, usually paying up in the process due to contango. This can adversely affect the price of an ETF like USO. Below is an example of how contango adversely affected the price of the 10 * USO 3 * Market Vectors Oil Services ETF (OIH) spread in late 2010 and early 2011. Notice the downward drift in the spread over time due to contango. This occurred during a period when oil prices rose sharply.

0.00

-10.00
-20.00 -30.00 -40.00 -50.00 -60.00 -70.00 USO-OIH

-80.00
-90.00 -100.00

Figure 31. Contango in 10 * USO 3 * OIH, Late 2010 and Early 2011

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If the futures price is lower than the spot price, the situation is called backwardation. Typically, backwardation indicates a current shortage, and contango indicates a normal or even a surplus situation. Volatility (VXX) and Natural Gas (UNG) are good examples of spreads trading in contango at the moment.

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Trading Options
In the chapter titled Choosing a Spread, we discussed cointegration as a metaphorical spring mean-reversion model. Options traders can incorporate this concept of a spring in their decision making to find spread patterns to exploit using options. The linkage between two securities can tip the advantage in the favor of astute traders who learn how to read what a spread tells them. Options strategies are numerous, and it is not our intention to go deeply into options trading. Our goal is to make you aware of the possibilities that spreads represent for options traders. There is no better way to do this than to give you one example of how we implemented an options trade using a cointegrated spread with positive momentum. On August 29, 2012, Bob Love (@boblove) and I posted the following tweets:

I replied that at the five-year time frame, the spread was cointegrated. You can view the spread in our analyzer at this link: http://goo.gl/5MqQq or in Figure 32.

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Figure 32. Cointegration of VLO HES Spread Looking at this spread, I noticed right away that VLO had strong momentum and that HES had plateaued at a short time scale (1 month). Given the strong cointegration at the five-year time scale, there was a good chance that HES could follow VLO on the
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upswing. I decided to sell a short-term put on HES. As I mentioned in this tweet, I wanted to use this trade as an example for this manual.

Figure 33. Cointegration of VLO HES Spread

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Figure 34. Short-Term Put Option on HES A week after I initiated this trade, I was able to unwind it for a $0.34 profit per option.

The reason I made money on this trade might have nothing to do with the structure of this spread. There are unlimited factors as to what justifies options prices. However, I do believe that if a trade pattern is statistically advantaged, the chance of a positive outcome is greatly enhanced.

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Creating a Playbook
Spread trading is a broad category encompassing everything that involves buying one security and selling another as a hedge. Within spread trading, there are many different strategies. You may stick to one strategy, or you may wind up trading a few different strategies. You might, within equity spread trading, allocate some of your capital to these strategies I have listed or any number of other strategies. Think of each strategy as a play in a football playbook. Sometimes you do a passing play and other times a running play; you need to mix it up to win the game. In certain market conditions, you use one strategy more and another strategy in other conditions, but it is helpful to have a mix of good strategies available to you. But before you can have multiple strategies, you need to develop one good strategy. There are many ways to develop a winning strategy. First, you start with an idea. Any one of the methods discussed in this booklet can be a starting point for your trading strategy. I keep a document where I start with my idea and add on over time as I refine my strategy. In my document, I lay out the universe of stocks (or spreads) that I will consider: for example, what countries I include, market cap limitations, liquidity limitations, sectors, and anything else I think is important. You may even specify a list of specific stocks or spreads you want to trade, if your strategy calls for that. I then write how I narrow down that universe of spreads to the ones I plan to trade on any given day. Those instructions will depend on what type of strategy you are developing. For example, this playbook is for statistical spreads, so I look for statistical arbitrage candidates trading around two standard deviations from the mean. Depending on your strategy, you might look at all stocks reporting earnings and find spread pairs to trade with the in-play names. You might look at a list of 30 stocks or spreads that you know well and look for trading opportunities there. I lay out my notional size per trade (which should be somewhat consistent or at least weighted by some guidelines). I then describe each trades entry strategy, exit strategy, and stop-loss strategy. Each strategy will typically start with an experiment, and I make a note of the parameters I want to experiment with. For example, a play might say that if a statistical arbitrage
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spread gets to -2 z-scores, then I buy it, targeting an exit at -1 z-scores. I might experiment with buying spreads at 1.5 z-scores or waiting until they get to 2.5 zscores. You can experiment by trading the strategy to see how it performs, or you can design a back-testing program to tell you how your strategy would have performed over certain periods. Back-testing programs depend on rigorous entry signals, so depending on your strategy, this may or may not be possible. Once you have a basic idea with some parameters to experiment with, you are ready to start with a few small trades. Start small at first until you are comfortable because you want to save capital for additional opportunities that will likely come your way. Test your first trading strategy with a few trades, and build a small portfolio of trades. Remember to diversify your entry points. To do this, think of your time frame for investment. Do you plan to hold each position a few days, a few weeks, or longer? Spread out your entry points across your holding period. If you plan to hold each trade for a month and you want 20 positions, then you should do approximately one new trade per day. Dont put on 10 trades on the first day, because you will soon run out of capital. Depending on your time frame, you may be able to build a small portfolio within a few days, or you may need several weeks. As you put on new trades and close old ones, experiment with the entry and exit strategies until you find what makes money consistently. Think of your playbook as a living document, where you update as you adapt strategies or as you discover what works and what doesnt. You may adapt to changing market conditions and come back to old strategies in the next market cycle. You can also add other factors: for example, what to do if a stock has just reported earnings or is about to report or whether to include or exclude M&A stocks. When I first started my spread-trading framework, it was a few paragraphs. Over time, I have grown it to many pages by adding successful trades, taking note of unsuccessful strategies, and tweaking my plays. When I have a very successful (or unsuccessful) trade, I add a chart of the trade and note my entry and exit points. If you are able to describe your strategy numerically, you may even be able to design an algorithmic trading program to trade it using an API. Or, you might keep the actual trading decisions up to you. For more information about building a spread-trading playbook, please watch our webinar here.
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Conclusion Conclusion
We will conclude with a list of some things weve learned, some of which apply to all spread strategies, and some of which are strategy specific. Be able to clearly identify and articulate your rationale for the trade, whether its statistical, fundamental, a liquidity gap, etc. Always choose an entry and exit point based on price and time. Know and understand the various risks involved in your trading strategy in general and in each trade you do. Continue to experiment and refine your strategy all the time. Maybe the market will change, in which case you will need to evolve to succeed. Or maybe your strategy is good but could be better with a slight tweak in parameters. To do this: o Keep track of the P&L of each trade and your entire portfolios. What types of trades are most and least profitable? Under what market conditions are you most profitable? Can you identify any patterns about which types of trades are more profitable in different market conditions? o Track the P&L of each spread after you unwind it. Perhaps you are unwinding too soon or not soon enough. o Track the P&L of each leg of the spread. Where are you making moneyon the long side or the short side? Keep track of general observations. Here are some that we have found. Think about whether you agree or disagree with these, and try to come up with observations of your own. o In our statistical book, we have found that it is not necessary to choose two stocks from the same industry. o For our statistical book, profits increased with increased volatility in the market. In times of low volatility, profits tend to be lower. o We have found that it is best to set your target profit and stop-loss so that they are symmetrical.

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Additional Material Additional Material

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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 people with many years of trading experience. I was explaining to them some of the statistical techniques we use at Bigger Capital. None of them was familiar with any of the basic statistical measures used in statistical arbitrage. Ive encountered the same thing when talking to other traders on different occasions. Ninety-nine percent dont have any idea of the basic concepts of statistical trading. And yet, none of these measures is new. Statistical arbitrage has been used as a successful strategy since the 1980s. So what are the basic measures that we use? We briefly define the primary ones below. They are the same statistical values we provide subscribers to our SpreadTraderPro tool. You can use these measures as a stand-alone strategy or combine them with other methods to enhance your returns. They are as follows: 1. Cointegration measures the degree of confidence that a stock pair that has diverged from its mean value will revert to that mean. 2. The z-score measures the distance the spread is from its mean value in standard deviations. 3. The half-life is the expected time it will take for the spread to revert halfway to its mean. 4. The zero crossing rate is the number of times the spread can be expected to cross the zero value for the defined period. A higher number implies a shorter holding period and a greater likelihood that the spread will not continue to trend.
5.

The sum of least squares 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 leg two.
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The Big Spread Debate


At Bigger Capital, we have different views on a critical issue regarding statistical spreads. The question is whether the two companies need to be similar (in the same sector or industry). 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. My 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 propositionthat two investments with the same payoff in every state of nature must have the same current value,9 regardless of whether the two companies are in the same or different businesses. The profit generated by the arbitrage is compensation for enforcing the LOP. Jennifers view is that the current price is the expectation of future cash flows, which are affected by many outside forces. Companies that have similar businesses will be affected similarly by small changes to inputs like interest rates, commodities prices, or consumer sentiment. A deviation in the price of a bank versus an oil company may be an anomaly, or it may be due to fluctuations in inputs that could take a long time to correct. For similar companies, it is more likely to be an anomaly that 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.
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Evan Gatev, William N. Goetzmann, and K. Geert Rouwenhorst, Pairs Trading: Performance of a Relative-Value Arbitrage Rule, available at http://www.google.com/url?sa=t&rct=j&q=&esrc=s& frm=1&source=web&cd=3&ved=0CCwQFjAC&url=http%3A%2F%2Fciteseerx.ist.psu.edu%2Fviewdoc %2Fdownload%3Fdoi%3D10.1.1.191.961%26rep%3Drep1%26type%3Dpdf&ei=YwzhTqDIJOLx0gG7h uXKBw&usg=AFQjCNFSNekAQh7gOiwJ1jeSz55nYDY-5Q&sig2=Rt99vufJpxWr2TVJgT72ug.

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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? Jennifer Galperin Comment on this text: Several months ago, I would have agreed with Jennifer, but I have since changed my mind. Ultimately, you are trading future cash flows, so it doesnt matter which industry generates those cash flows. It is almost impossible to gauge how the various factors you mention affect short-term price fluctuations, even within the same industry, so you let the stats tell you the likelihood of those fluctuations being noise or real. Norm Winer

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Trading Insider Purchases


We are monitoring the $XLK $VMW $spread based on recent insider activities. We are hoping that we can get a spike in the 10 * $XLK - 3 * $VMW to the 20 level. We have used the My Alerts feature of our Spread Analyzer to monitor this $spread for us. Located below, are all the documents supporting our thesis. As the insider buying, we think it is bullish for VMware, Inc. (VMW) (bearish for the spread). If the $spread reaches the $20 level, we will be happy sellers.

Figure 35. Purchase History of VMW

Figure 36. XLK VMW Spread History

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Figure 37. Spread Analyzer XLK VMW

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I Wish I Had Learned to Trade This First


A while ago, I wrote a blog post about Starting Over. There are a lot of things I wish I had known when I started my trading career. One thing I wish I had done was to learn how to trade 8 * $SPY 13 * $IWM. This is my favorite trading vehicle. I think most traders should keep this spread on their screens. The trading apprentice should play with it in a sandbox. Here is the statistical rundown on it: For a larger image, click here.

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Figure 38. Spread Analyzer for SPY IWM


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Figure 39. Spread Analysis SPY IWM If you want to become a professional trader, there is a lot to learn. When you are first starting out, SPY IWM is a great product because it is liquid, is easy to understand, can be traded on a short (but not instant) time frame, and provides lots of opportunities to make money. It will help you learn some of the subtle yet important aspects of trading, such as:

Setting probabilistic and symmetrical stop-losses Understanding emotion and its impact on the market Interpreting liquidity gaps and spikes Finding pricing lags in one security versus another Recognizing changes in the market environment, and how to adapt your strategy Comprehending intraday time windows

What is your favorite trading vehicle?

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Darwin the Trader Charles Darwin is widely known as the man behind the theory of evolution. He theorized that through evolution, a species could adapt to different environmental conditions. Those individuals who did not adapt would not survive to pass along their genes. A friend said to me the other day, It is the markets fault I lost money trading last month. I could have agreed with my friends opinion since I have spent the last two years building my quantitative strategy, and I have had plenty of setbacks along the way. But now, in the current low-volatility environment, I am making money trading my strategy at a short time scale, choosing my entry points wisely, and capitalizing on many small gains. At various points in my journey so far, I have had to cut limbs to survive. I had to admit I did not know much about quant strategies when I started. I made mistakes, and I took steps back to think. I iterated, retested, and moved forward. What has worked for me is to adapt to different market conditions all the time. Like a football team, I started by building a book of plays that will work at different times, against different opponents, and in different market environments. I learned that what worked last week may not work this week or next week. I need to understand my opponent by recognizing trends, inflection points, and themes in the market, all of which can change on a dime. I use my growing playbook to exploit this situation. If you build a good playbook, you will have the trades set to make money in any market conditions by adapting and evolving. A playbook is the tool I have built to adapt. So how do we adapt? For quantitative traders, this can be one of the hardest things to do. Computers dont learn and adapt; they just crunch numbers. Humans need to think carefully about the inputs. Maybe that means we ask the computer to look at performance of the strategy in bull and in bear markets, in low- and high-volatility environments, or in times when oil prices are low and highwhatever we think might affect our strategy. Maybe we find that when certain market conditions are in effect,
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we need to tweak our strategy (or radically change it). Then, experiment with the change. Try one or two small trades to see how they perform. But dont get too comfortable, because the next change in the market is just around the corner.

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Learn To Trade Like a Math Geek


In March 2012, we held a webinar titled Learn to Trade Like a Math Geek. We discussed some of the key math terms involved in statistical arbitrage spread trading. Many of the questions were specifically about calculations and how they are done. It is important not to get too bogged down with the math. Cointegration tells you that the two stocks have a history of reverting to a mean level, like a spring. When you design your statistical arbitrage trading framework, you want to build a portfolio of these spreads. You should see that most of them behave nicely, while a few continue on their trend away from the mean. Youll develop your own recipes for determining when spreads will behave well and when they will not. You may even develop some recipes for trading spreads that are different, like the earnings strategy we discussed at the end. The beauty of statistical arbitrage spread trading is that you can design your own strategy in whatever way you find works best. Here is the replay of our webinar.

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Spread Trading and Takeovers One morning I came in short Taleo (TLEO) at about $39.50 as part of a spread I initiated the previous day. Oracle announced that morning that it was buying TLEO for $46 per share. Bad news! How do you prevent something like this from happening? The short answer is that you cant. But there are a couple of things you should be doing to lessen the pain and decrease the frequency of such events. First, you should create a diversified portfolio that can withstand such a move. TLEO represented less than 2% of the portfolio. Second, you should be certain that your process is not getting you into situations like this on a regular basis. If it is, you might want to rethink your strategy. In our case, it hasnt. Sometimes weve been on the winning side of these events. If your process is sound and your portfolio is diverse, events like this will occasionally occur, but they shouldnt prevent you from being profitable over the long run.

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Taxes
Readers are advised not to act upon this information without seeking the service of a professional tax and/or financial planner. Spread trading can create complicated tax issues, and spread traders should review their spread-trading tax implications with their professional tax advisers at least once a year. At BiggerCapital we trade spreads in a Section 475 election trading vehicle. You can learn more about this right here. Please discuss this and any other tax issue with a professional who understands your specific situation

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