Tuesday, September 17, 2013

Pair Dynamics...9.17.13

I mentioned the MO2 pairs trading software platform before and some of its features are explained on the etfmosaic homesite.

Using the relative strength of each side of a pair trade can provide a valuable confirmation of momentum that is not evident by analyzing either the P6 slope or the TrendX.  If 2 heads are better than one, then 3 must be even better for trend validation.

In the case of yesterday's XLF model, C (Citigroup) was chosen as the pair component and, as can be seen from the charts display below, the relative strength relationship between these 2 issues can indeed provide some insight when considering the odds of a profitable trade based on current market dynamics:
These are the net results over a 6 month lookback and we have applied no time stop which, we can show, is a powerful tool for containing drawdown and avoiding capital dribble.
In the XLF / C pair we have looked at a convergent pair...that is both issues tend to move in sync with one another and our strategy is to play the strong issue against the weaker issue.

If we take a more holistic view and look at the signals generated by both convergent and divergent (issues tend to move contrary to one another) pairs with the similar focus pair issue (A), then we produce a more
reliable scenario for successful investing.  In the case below we use XIV (VIX inverse) and a divergent pair component (SH) and a convergent pair component to create such a probability picture:
To improve our odds even further we have applied a 10 day time stop for each trade even though the relative strength cycle for both pairs averages 28 days.
In future posts we'll explore more nuances of the pair analysis that make consideration of the current pair dynamics worth a critical look.