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Statistical Arbitrage Is Not Rocket Science

I’m going to say it right up front…you don’t need any special knowledge to use Statistical Arbitrage, also known as StatArb. All it is, is a fancy name for pairs trading. But even that term, pairs trading, makes some traders unsure. It has too many moving parts, and people struggle to understand how one profits by buying one asset and selling another.

But it’s not that complicated, StatArb removes the one thing from analyzing the markets that is so difficult to achieve, and that’s predicting direction. StatArb is agnostic to direction, it allows you to profit under conditions that might normally seem untenable. The amazing thing about a StatArb trade is that it trades the relationship between two correlated assets, which by its very nature provides a well defined and highly probabilistic edge.

Another great thing about StatArb is that it provides risk aversion in a naturally hedged position, you don’t have to care which way the market goes, and with futures you get substantial discounts on the cost of the trade. And all you have to do is follow a couple of very simple rules.

Is StatArb a fool-proof methodology? No, but it does remove most of the things that haunt directional traders. The only real problem with StatArb is the availability of easy to use, and intuitive tools across popular trading platforms. That’s probably the principle reason that retail traders have not adopted the strategy.

How Does StatArb Work?

The whole premise of a StatArb pairs trade is to match two highly correlated assets and trade the difference in value. This difference in value represents the change in relationship. If two things are very similar, and the relationship gets disrupted, there’s a high probability that the relationship will eventually regress back to its norm.

So, the way you trade StatArb pairs is wait for a disruption, measure that disruption using statistical measures, typically one standard deviation, then take the trade by going long the underperforming side of the pair, and short the over performing side. Then you make money as the pair regresses back to their norm, closing that gap between them.

The probability that the divergence or disruption will repair itself is very high if the pair are highly correlated. Which basically means that they move with each other under all kinds of conditions. You can measure this level of correlation using statistical tools. The most common way is to measure the pairs correlation coefficient, which has a range of -1 to +1. A score close to +1 means the pair is correlated. Most StatArb traders consider a score > 0.5 to be good enough to trade.

There are mathematical proofs that show very high correlations (> 0.70) make the probability of a regression virtually a given, greater than 75%. This is the kind of edge traders dream of.

How Do You Chart the Relationship?

Most trading platforms allow you to include 2 or more symbols on a chart, then use scripts to plot the relationship. Some platforms do it better than others. Let’s look at Think or Swim (ToS) for example. To plot two stocks or futures is very simple, let’s look at the Gold and Silver ETFs GLD and SLV respectively. You can enter the simple formula “GLD – SLV” in a chart and ToS will plot it.

By the way, there are lots of great tools for calculating correlations of stocks and ETFs on the web, here’s one specifically for ETFs. Below is a chart created with TradeStation, using special indicators that plot the pair for you. There’s also a Correlation indicator showing the running correlation Coefficient, currently at 0.51. The correlation shows that the correlation has been steady, hovering a bit above the 0.50 mark.

 

Both these charts plot the value of one share of GLD minus the value of one share of SLV, currently at $101.34. You can apply any kind of traditional charting tools and indicators to determine buy and sell points, just like any single stock or ETF or future. But because we are doing statistical Arbitrage, it is generally accepted that you will measure pivots points using statistical tools. A very common tool to use is called Z-Score. It’s shown below.

A Z-Score indicator is similar to an RSI or Stochastic, but it shows the number of standard Deviations the pair has moved relative to a zero line. The indicator below has a 2 standard deviation alert line that generates a signal when the pair has moved that amount. These are potential places that you might use to take trades

The chart above is for illustrative and educational purposes only. I’m not implying a trading strategy or recommending that these trades should be taken. In fact, there’s still more work to do before you get to that point, just like any strategy. But keep in mind, we’re plotting the relationship between GLD and SLV, not the direction of any one of them, so our strategy should be predicated one that idea.

While some people might just plot the two ETFs and think that’s good enough, but it’s not. You need to make sure both assets are equally represented in terms of their underlying value, also known as the Net Asset Value (NAV). In other words, you have a ratio of shares that represent an equivalent value of gold and silver. There’s a fairly substantial amount of academic and practical research that shows this is necessary. With an ETF this requires some research. With futures it is a simple calculation of multiplying the quoted futures price by the asset’s Big Point Value, which is a component of every futures product.

My TradeStation indicator, which I developed, plots pairs of assets, and automatically does the value calculation for you when you apply two futures products. You can also specify any ratio of contracts you want. Some pairs require a certain ratio in order to get the full discount on your margin requirements. This is a feature of futures, not stocks and ETFs, where the Chicago Mercantile Exchange determines this discount based on their reduced risk calculation as a result of your hedged position. In other words, it’s cheaper to trade futures when doing StatArb than stocks, and you get way more leverage and tax benefits too.

How To Execute a Pairs Trade

This is the final thing you need to know in order to execute a pairs trade. You must execute both sides of the trade simultaneously. Do not try tole into a trade by executing the long then the short or vis a versa. You may get away with it a couple of times, but eventually you will experience pain. But don’t fret, there’s a super simple way to execute both sides of the trade at the same time. It’s a feature in most trading platforms called Order Sends Order (OSO). You simply setup the OSO order and execute it with one button click.

TradeStation has something called Staged Orders in the TradeManager that lets you set up OSO orders. Think or Swim has a couple ways to do it, the easiest is to use their Pairs Trading Platform. The other way is to set your order to Blast All and add both sides of the trade to your order list. And that’s it!

Conclusion

Once you have done these few required things, trade a correlated pair, execute the trade simultaneously with an OSO order, you are good to go. You just need a plan and a strategy, and you can become a Statistical Arbitrageur, making high probability trades, without a care as to which way the market is going.

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How To Trade Oil Futures – The Basics

Crude oil (CL) is one of the more active commodities to trade. It has tremendous volatility and excellent liquidity. Oil is affected by global economic and political conditions, almost to the same extent as US Treasuries. The price of crude oil affects the price of many other assets, including stocks, bonds, currencies and even other commodities. This is because crude oil remains a major source of energy for the world and is a defect currency in many ways.

Crude Oil Contract Specifications:

  • Ticker Symbol: CL
  • Exchange: NYMEX
  • Trading Hours: 9:00 AM – 2:30 PM EST.
  • Contract Size: 1,000 U.S. barrels (42,000 gallons).
  • Contract Months: all months (Jan. – Dec.)
  • Price Quote: price per barrel. Ex $65.50 per barrel
  • Tick Size: $0.01 (1¢) per barrel ($10.00 per tick).
  • Last Trading Day: 3rd business day prior to the 25th calendar day of the month preceding the delivery month.

Cude Oil Fundamentals

  • Light Sweet Crude Oil is traded on the New York Mercantile Exchange (NYMEX). “Light Sweet” is the most popular grade of crude oil that is traded.
  • Crude oil is the raw material that is refined to produce gasoline, heating oil, diesel, jet fuel and many other petrochemicals.
  • Russia, Saudi Arabia, and the United States are the world’s three largest oil producers.
  • When crude oil is refined, or processed, it takes about 3 barrels of oil to produce 1.5 barrels of unleaded gas (RB) and 1 barrel of heating oil (HO).​

Crude Oil Reports

This report is released every Wednesday at 10:30 PM EST, unless there’s a holiday, then it’s released on Thursday at 11 AM EST. The report is usually considered bullish if the actual reported inventory is significantly lower than the expected inventory level, and bearish if it is higher. We say usually because there may be other factors that could affect how the market perceives the report, such as seasonal conditions, or storage anomalies.

TIP: On the days of the report, if you are a day trader or scalper, my experience says don’t trade Crude Oil between 8:50 Am and 10:35 AM EST. The market is erratic on report days during these hours. Wait until the report has had a chance to settle and the market digests its content before trading.

Price Movements

The price of crude oil (CL) is highly correlated to the economics of gasoline (RB) and heating oil (HO). In fact, all three of these contracts are often traded together either for hedging by refiners, or speculation by professional traders in what is called the Crack Spread.

The Crude Oil market is by and large a trending market. There is a high level of volatility however, which can cause price to jump or plummet. These spikes are typically followed by a regression back to the mean direction, unless the event results in a major supply disruption. Crude often gets stuck in prolonged ranges after a big move, identifying these ranges is crucial to exploiting excellent trading opportunities.

The U.S. dollar is a major component in the price of oil. A higher dollar puts pressure on oil prices. A lower dollar helps support higher oil prices. Crude oil also tends to move closely with the stock market. A growing economy and stock market tends to support higher oil prices. However, if oil prices move to high, it can stifle the economy. At this point, oil prices tend to move opposite the stock market. This usually becomes a concern when oil moves above $100. In the past, prices in the $120-130 range bring about capitulation.

Profit Targets for Day Traders

When day trading Crude Oil futures set your profit target between 0.15 to 0.20 cents. This seems to be in line with the intraday swings for the CL contract.

A Target of 0.15 cents with a single full-sized contract translates to $150 ($10/tick or 0.01) and 0.20 cents equals $200, so that’s plenty of profit potential but it’s not going to make outsized demands on your trading strategy like if you were shooting for a lot more, like 0.40 or 0.50 cents. I’m not trying to tell you there aren’t bigger moves, in fact I’ve seen plenty of times rallies go well beyond $1.00 or more. I’m just trying to give you a target that can make profits consistently.

Day Trading Crude Oil Futures

Crude oil is one of the favorite markets of futures day traders. The market typically reacts well to pivot points and support and resistance levels. You have to make sure to use stops in this market, as it can make very swift moves at any given time. It is best to day trade within the context of a larger global macro strategy, rather than rely on pure technicals.

There is no shortage of trading opportunities in crude oil from day to day. The market is very active and it has plenty of volume. Crude oil is a 24 hour market, so be cautious of possible overnight moves that can take you by surprise. Much of the same principles that apply to stock index futures also apply to crude oil futures. If you like trading the e-mini S&P, you will probably like crude oil too.

Crack Spread Trading

In my opinion, day trading technicals is too risky, but many traders find it okay. I prefer to trade a spread, like one of the Crack spreads. My favorite is Crude (CL) vs. Heating Oil (HO) in a 1×1 spread, because of the very high correlation between the two products (r = 0.90 on a daily basis). This provides a level of risk aversion because it’s essentially a hedged trade. The primary trading methodology is mean reversion.

There are other popular Crack Spreads, such as Crude (CL) vs Gasoline (RB), and an all inclusive trade with Crude, Heating Oil and Gasoline, which is usually traded in the ratio of 3x2x1, but this is typically the type of trade a refiner would do to hedge their business

I trade Crude vs Heating Oil, and offer a course and mentorship program for this spread. If you are interested in learning to trade the Crack Spread, contact me at 508-446-0517. And look out for future posts on the Crack Spread.

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What Is The BoB Spread?

The BoB spread is a type of yield curve spread, it depicts a spread between the very longest maturity treasuries, the 30-year Bond and the 30-year Ultra Bond. So, what’s the difference, and why is this such a good trading vehicle?

Here’s the part of the yield curve that the BoB spread represents, indicated by the segment in red. It is very unusual for this segment to be pointing down, while the rest of the yield curve is pointing up.

The BoB spread represents the delivery of the longest maturity treasury products. But wait, they are both 30 year bonds, right?

Yes, it is true, they are both 30 year bonds, but the treasuries they can potentially deliver upon expiration when the contracts expire is very different. What you probably don’t realize is that when a Bond futures contract expires, you don’t get a pristine Treasury with a full 30 years left until maturity, what you do get is a possible range of previously issued 30-year bonds that could have a wide range of time left until they mature.

30-year Bonds deliver a product with between 15 and 25 years left until maturity, while 30-year Ultra Bonds deliver between 25 and 30 years left until maturity. Because the Ultra is further out there, the face value is generally priced a bit higher than the regular 30-year bond. Also it’s price is a bit more volatile.

Highly Correlated

The good news for traders is that because they represent essentially the same thing, just different groupings of the same thing, so they are highly correlated, and as such make excellent spread trading partners. The correlation between these two products generally hovers in the high 80s and low 90s on the correlation coefficient scale.

Excellent Movement Tied to Global Macro Events

The BoB spread is an excellent barometer of where the economy may be heading. It is often used as a leading indicator for the shorter maturity Treasury products. In fact, right at this moment, it appears that long bonds are predicting a flattening of the yield curve, with a rather significant divergence over the past week or so.

You can see this very clearly on the yield curve chart at the top of this post, as well as the change in the moving average in the notional chart just above.This is the Bond market saying they expect some sort of change in global events that will affect things well into the future for the worse, perhaps this is a prediction of the French election.

Bonds Lead All Markets

There’s a reason it is often said that the smartest traders on the planet are the bond traders, and that’s because they are also tuned into all the big global macro events around the world. So, if you like trading in the big picture, there’s no bigger way to trade than with Treasuries and the yield curve.

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Highly Correlated Spreads

Spread or pairs trading is a very effective way to hedge your risk exposure to the movements of the broader market. With pairs trades you can make profits through simple and relatively low-risk positions. The trade is market-neutral, which means the direction of the overall market does not affect profit or loss…it’s the change in the relationship between the pair that you are trading.

The primary goal in choosing a pair to trade is that they are highly correlated. This correlation ensures that you are trading the relationship and not the price. You make profit by waiting for the difference in price to diverge by some statistically significant amount. This change represents the divergence in the relationship. At some point this relationship has a very high probability of regressing back to the original price difference. The higher the correlation, the higher the probability that the relationship will regress back.

So, we use statistical tools to measure correlation with a measure called the correlation coefficient, which is on a scale from -1 to +1. A +1 indicates perfect correlation, while a -1 indicates perfect inverse relationship. There are virtually no pairs with perfect correction, but pairs with coefficients above 0.70 are considered to be candidates for pairs trading. Mathematical proofs have shown such pairs have a 75% probability of regressing after a divergence.

This is a very strong edge that traders can use to their advantage. And the reason why pairs trading is so popular with hedge funds, investment banks and professional traders. Very few retail traders use the strategy because there are few good intuitive to use tools available. FYI, if you take my course you will be provided such tools.

Finding Great pairs Can Be Challenging

Unless of course if someone does it for you. And that’s what I have done for you here. I have ferreted out the futures contracts that have the highest correlations. I personally trade most of these pairs using a proprietary methodology and set of rules, employing a strategy called statistical arbitrage.

 

The “r” value is the correlation coefficient of the pairs shown. The charts plot the difference in the notional value of the pairs. That’s what we analyze using statistical tools to determine when to act on the trade. All the pairs use a ratio of 1 to 1. Meaning the smallest position size would be 1 contract long and 1 contract short. My favorite trades happen to also be the most highly correlated. Two are Treasury futures called the NoB and FYT, and the other is an Energy futures pair called the Oil-Heat which is a type of Crack Spread.

There’s a fantastic tool available on the CME Group website that helps identify the most highly correlated pairs called the Cross Correlation Calculator. The screen shot below shows the tool, and I have blocked off the most correlated pairs. There’s very few that every achieve a correlation Coefficient higher than 0.60, which is the standard I used for blocking them off. I wouldn’t trade the pair unless it had a value greater than 0.75.

In future articles I’ll go over each of these pairs and talk about specific strategies that can be employed on top of the basic statistical arbitrage strategy that will further increase your probability of profit. If you would like to learn how to execute those strategies now, then sign-up for my course, it’s a fantastic value, and includes one-on-one lessons and mentoring.

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Yield Curve Is Flattening But Which Spread Should I Trade?

There are many variations of the yield curve to trade, and it can be confusing which is the right one for your needs. So you may be wondering, which should I trade?

The answer is relatively simple, if you understand your personal capacity and tolerance for risk, and whether you are a long-term or short-term trader. Another consideration is a bit more practical, as some of the spreads may cost significantly more on a risk-return basis than others. So, this is your homework before you put your money to work.

The charts below show a bunch of different yield curve spreads involving the 2-year note as the front leg. Going clockwise, starting from the upper left chart, it includes the Ultra 30-year bond (3:1 ratio), the 5-year note (1:1 ratio), the 10-year note (2:1 ratio), and the 30-year bond (3:1 ratio). The chart also shows the range in price of the spread, with a high in March and a low in April of 2017.

So, from a risk perspective it’s clear that the spreads with bigger dollar ranges present more risk. These are the TUL and TUB spreads, which pair up the 2-year with the 30-year bond and ultra bond respectively. The TUL and TUB are also a bit more expensive to put on as well because there are more contracts necessary to execute the proper ratio trade, but the expense to return is much lower than the other two.

A large range would indicate more risk, depending upon the size of your account. A very large account would have greater flexibility, while a smaller account may be restrictive to certain spreads. Small accounts would find the TUT and TUF spreads more palatable.

The TUT and TUF spreads are also slower moving than the TUL and TUB, as they react more slowly to global macro events and changes in monetary policy. So, these spreads may be better for someone that is not as active a trader as others, or prefers position trading over swing trading styles.

The downward arrows indicate a flattening yield curve, so the appropriate strategy would be to short the spread. This means short the front leg, and go long the back leg. It’s a flattener trade when we have a downward sloping moving average. This simply implies that the front leg of the trade (2-year note) is weaker than the back leg, evaluated since the beginning of 2017. One can assume that longer term yields are falling faster than shorter term yields, and are likely to continue that way, so long as the trend is down.

Conclusion

So to sum it up, if you have a larger account and are a more active trader, then the TUL or TUB spreads may suit you. If you have a smaller account, or you prefer a trend trading style, then the TUT or TUF spread may be best for you.