Trade Like A Hedge Fund: Unilateral Pairs Trade

• Posted by DynamicHedge
• on March 20th, 2011

I read James Altucher’s “Trade Like a Hedge Fund: 20 Successful Uncorrelated Strategies and Techniques to Winning Profits” a few weeks ago.  I love James’ blog and I was pretty excited to read one of his books.

This is a must-read for anyone who wants to understand how to think about trading and strategy development.  Finding a new profitable idea can be as simple as looking at a familiar strategy through a new lens.  Just reading and following his thought process and then reflecting on my own strategies has generated at least two quality ideas for my own trading.

Here’s a quick overview of the  “Unilateral Pairs Strategy.”

Strategy Basics:

• Find two instruments that are correlated with one another where one instrument is significantly more volatile than the other.
• Plot a ratio spread of the two stocks with a 20-period MA
• Calculate the standard deviation of the ratio from the 20-period MA
• When the spread deviates two standard deviations from the 20-period MA you will be looking to initiate a trade.
• If the spread is two standard deviations up and it’s because the volatile stock is  also up, you short the volatile stock.
• If the spread is down two standard deviations because the volatile stock is selling off, you take a long position in the volatile stock.

Basically you’re using relationship data to generate trade setups rather than simply using flat price data.

I’ve traded plenty of pairs where whether you like it or not, you’re just trading a single stock.  Your “hedge” is nothing more than added commissions and haircut.  This is why I try to avoid these lopsided volatility relationships without a specific strategy or catalyst in mind.

I love that this strategy gives me a reason to re-explore spreads that I’ve previously dismissed as “crappy spreads.”  Is there an edge to trading these relationships in a one-sided manner?  Has the strategy evolved from when James first wrote about it?  Is there a better way to analyze the relationship between stocks in order to filter losing trades?  These are all questions I’ll be exploring in the next few weeks as I drill down into this strategy and the other ideas that reading this book excised from my brain.

James has some additional specific numbers that go along with the strategy, but I didn’t include them because A) you should experiment and figure out what works and what doesn’t, and B) you should pick up a copy of the book if you want to have a look at the full strategy and all the code that comes with it.  I can’t recommend this book enough, very entertaining and full of ideas.

Trade Like a Hedge Fund: 20 Successful Uncorrelated Strategies and Techniques to Winning Profits (Amazon)

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