1
$\begingroup$

I'm constructing money-neutral spread by this formula:

Spread = log(P1) - log(P2), where P1 and P2 is prices of two instruments

But sometimes spread can get into negative zone, when log(P1) < log(P2). How to avoid this and make spread always positive?

Improve this question
$\endgroup$
  • $\begingroup$ Adding additional information may help us understand your needs. I mean: why not a simple value? $\endgroup$ – pincopallino Apr 10 '14 at 6:57
  • $\begingroup$ spread sign is not important. P&L will be determined by change in equity line. $\endgroup$ – Wisentgenus Apr 10 '14 at 7:17
  • $\begingroup$ My backtesting program accepts only data with positive quotes. I want to backtest this spread like standalone instrument. $\endgroup$ – Eldar Agalarov Apr 10 '14 at 8:05
  • $\begingroup$ Multiply it by $-1$. $\endgroup$ – user2763361 Apr 10 '14 at 8:48
  • $\begingroup$ but if spread sometimes is positive, sometimes is negative? $\endgroup$ – Eldar Agalarov Apr 10 '14 at 9:17
1
$\begingroup$

Solution is following:

  • Calculate the spread: spread = log(P1 / P2)
  • Find minimum value of spread: minVal = Min(spread)
  • If minVal < 0 then do transformation for spread: spread = spread + Abs(minVal) + 0.01

Now we have spread with positive values.

Improve this answer
$\endgroup$
0
$\begingroup$

My understanding is following:

Spread = Log(P1) - lambda * Log(P2) Lambda is the hedging ratio to eliminate market risk

Assuming the two securities are cointegrated, if Spread is positive, security P1 is relatively more expensive than P2. As a trader, you might want to consider short P1 and long P2.

If Spread is negative, security P1 is cheaper than P2 in relative term. So one might want to long P1 and short P2.

Improve this answer
$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.