For one of our ten day trades this week we are going to look at a unilateral pairs trade. Here is how this works, we compare two instruments, in this case the SPX and RUT, that are highly correlated but trade at different volatilities. The RUT is very volatile compared to the SPX. What we are attempting to do is find points where the indexes are trading apart at extremes entering the volatile instrument for a more “normal” return to the relationship.
The charts are setup like this.. We create a relationship between the closing price of the SPX/RUT. We take a 50 day moving average of this ratio and when we slip 2 standard deviations below the 50 day average of this ratio we expect the RUT to return back to the average and we will trade on this return. The trade triggers when the average crosses back above the -2STD line. Currently on a daily basis we are sitting below that line and this is how the chart was setup this morning:
To maximize the volatility and profit we will use TNA. The strategy was back tested using RUT.X since TNA does not give us enough historical data (just 3 trades all of which produced winners). Here are the results using the RUT as the instrument to buy..
The parameters:
Trigger as described above..
Hold for 10 days or
2.2% profit, which ever comes first
Profit Curve:
To maximize our profits we will trade the system using TNA. We will use the following parameters:
Hold for 5 days or
6.9% profit
Data substituting in TNA:
Don’t get too excited over the 100% number.. there were only 3 trades.
As of writing this post this system has not triggered.. it needs a close above that trigger line.. but intraday right around 10:30am EST we have crossed the trigger line but it does need to hold there into the close.. stay tuned and watch my twitter feed for a go-no-go near the close.
@RedlionTrader
disclaimer:
These trades are back-tested but no one can predict what happens in the future. There is a small test sample and I may or may not take either trade. I present this as pure research. If you take the trade and it turns out badly you have been warned. If it turns out great than you are welcome. I believe the data to be accurate but I am only human so you should verify these trades yourself.
