2
$\begingroup$

I'm setting up pairs trades by summing the distances squared (SSD). After determining the best pairs, I have to track the spread between the normalized prices. Am I noticing something that is bothering me or am I doing it wrong?

When I opened the transaction it was not cash neutral: For example, the long positions is for \$26,628.00 and the short one for \$29,886.00.

Watching the spread between normalized prices, can there be situations where my spread is moving towards the mean (further away from the average), resulting in losses? Will have to wait for the mean-reverting process to complete?

PS: So the spread will depend on the amount and size of stock purchased. Would that influence the behavior of the spread?

$\endgroup$
3
$\begingroup$

Of course. Even if you started dollar neutral, the spread can continue to move away from its mean resulting in losses. Pairs trading isn't an arbitrage situation, it simply asserts that given correlated assets, their spread will revert to the long run mean if and when it does deviate.

| improve this answer | |
$\endgroup$
  • 1
    $\begingroup$ @Chris many thanks! My question arose because I am following the chart of the normalized spread. and when he pointed in the direction of the mean, it gave me no gain. Thanks to your answer I understood that I do not have to set a stop gain when my normalized spread reach zero (fully revert to average). So what we need to do is "capture" the change in spread. Entering when the spread is 2 standard deviations from the average the chance increases. Am I right? $\endgroup$ – Laura Oct 9 '19 at 13:03
  • 1
    $\begingroup$ @Laura, that's the general idea, yes. That's part of the variability of a strategy like that though. There's a risk to setting your entry point to be something like 2SD because you'll miss out on some opportunities, and yet strength of mean-reversion may not be sufficiently strong if you enter at 1SD. Not to mention, you're suffering losses as long as your spread continues to move away from its mean, which can be an issue if you're highly levered. $\endgroup$ – Chris Oct 9 '19 at 22:48
  • $\begingroup$ amzing. Thanks for your time! $\endgroup$ – Laura Oct 11 '19 at 13:23

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.