The current signal (Long NDX and short INDU, market is up) since April 30 is performing well. The long/short position is making 0.8% and the market timing is net 2.04% in NDX, or 1.4% in SPX.
Wednesday 27 May 2015
Sell in May? Not yet.
The NASDAQ 100 Index closes today at all-time high. Is it time to sell and go away. Our model tells not yet.
The current signal (Long NDX and short INDU, market is up) since April 30 is performing well. The long/short position is making 0.8% and the market timing is net 2.04% in NDX, or 1.4% in SPX.
We are waiting for the short signal to reverse the trade.
The current signal (Long NDX and short INDU, market is up) since April 30 is performing well. The long/short position is making 0.8% and the market timing is net 2.04% in NDX, or 1.4% in SPX.
Tuesday 19 May 2015
Market view: Peak or Continuing
The S&P 500 Index has increased over 1% since we traded positions of long in NASDAQ 100 and short in Dow Jones Industry Avg in the morning on April 30. As we pointed out in other post, the signal suggested the US equity market would go up. The performance of equity indexes since then has confirmed the market direction.
Now that the S&P 500 Index is hanging on the all-time high level, will this be the peak or the up trend will continue?
Even though the equity market is up since we openned the long/short future positions, the P&L of the trade is still negative, which implies that growth stocks have underperformed value stocks in May so far. The status of the index pairs trading model suggests that US equity market will keep going up until the model tells us to long Dow Jones Industry Avg Index and short NASDAQ 100 Index.
Now that the S&P 500 Index is hanging on the all-time high level, will this be the peak or the up trend will continue?
Even though the equity market is up since we openned the long/short future positions, the P&L of the trade is still negative, which implies that growth stocks have underperformed value stocks in May so far. The status of the index pairs trading model suggests that US equity market will keep going up until the model tells us to long Dow Jones Industry Avg Index and short NASDAQ 100 Index.
Friday 15 May 2015
Draw down and risk management
Both the backtesting results and live performance have demonstrated that our index pairs trading strategy works well in different market conditions. Some readers are wondering the downside risk of the strategy and how to handle this risk.
First of all, we list the maximum unrealized loss of each trade since January 2015, and calculate the maximum drawdown in different leverage scenarios, as shown in following figure:
In the first scenario, we trade 1 contract in the long/short positions for each $20,000 cash in the account. The effective leverage is about 2. 8 trades have maximum drawdown of less than 3%, and the biggest drawdown is 9.7%.
In the second scenario, we open 1 pairs of future for each $10,000 cash in the account. In this case, the effective leverage increases to about 4. As we can see from the above table, the maximum drawdown in each trade also increases. The biggest potential loss is about 20%.
This scenario analysis suggests that controlling the leverage level is one of the key steps to a successfull risk management. Less leverage leads to more stable wealth cure while limiting the growth. We would need to balance the risk and the return, and choose the appropriate leverage based on own risk budget.
Aternatively, we can change the strategy so that it can response to the market faster and hence reduce the holding period. Recall that the model has strong market timing ability. We design a second version of pairs trading strategy that bases on the initial model and the performance of the timing market portfolio. We calculate the momentum of the market portfolio and use it to turn on or off, and even reverse the pairs trading. The number of trades since January 2015 increases from 11 to 47, and the wealth curve is smoother than the original one's. See following graph for demonstration. It's worth pointing out that the higher-frequency trading is not neccessary always better than the original trading.
First of all, we list the maximum unrealized loss of each trade since January 2015, and calculate the maximum drawdown in different leverage scenarios, as shown in following figure:
In the second scenario, we open 1 pairs of future for each $10,000 cash in the account. In this case, the effective leverage increases to about 4. As we can see from the above table, the maximum drawdown in each trade also increases. The biggest potential loss is about 20%.
This scenario analysis suggests that controlling the leverage level is one of the key steps to a successfull risk management. Less leverage leads to more stable wealth cure while limiting the growth. We would need to balance the risk and the return, and choose the appropriate leverage based on own risk budget.
Aternatively, we can change the strategy so that it can response to the market faster and hence reduce the holding period. Recall that the model has strong market timing ability. We design a second version of pairs trading strategy that bases on the initial model and the performance of the timing market portfolio. We calculate the momentum of the market portfolio and use it to turn on or off, and even reverse the pairs trading. The number of trades since January 2015 increases from 11 to 47, and the wealth curve is smoother than the original one's. See following graph for demonstration. It's worth pointing out that the higher-frequency trading is not neccessary always better than the original trading.
Friday 1 May 2015
The implied market timing ability behind the index pairs trading
In the "The theory of pairs trading" post, we point out that "In a bull market, growth stocks tend to outpace value stocks, and in a bear market, value stocks perform better". In other words, when the pairs trading model suggests to long NQ and short YM, the market is likely to go up, otherwise, the market is likely to drop. This is the implied market timing ability of the index pairs trading model.
This timing ability can be demonstrated in above transactions. During all 5 completed "long NDX short DOW" trades, market indices were all up, while in 3 of 5 completed "short NDX long DOW", the market was down. Therefore, the timing probability is 80%! The current signal is "long NDX short DOW". Even though the US market dropped on April 30, the market recovered the loss on May 1st, suggesting that market indices are likely to go up when we close the current transaction. By the way, the current trade reverses to make about $60 from yesterday's -$331.82 loss.
This timing ability can enable us to improve the performance significantly. We can buy call or put options on indices or ETFs based on signals to add addition returns to the pairs trading.
This timing ability can enable us to improve the performance significantly. We can buy call or put options on indices or ETFs based on signals to add addition returns to the pairs trading.
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