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12

2.6.5 Emulex-QLogic

Figure 2.8 is an fllnstration of how a news item creates opporrunit}. QnJanuar} 23rd, 2002, QLcc Corporation reported eamings after the closing bell, but then commented on "limited visibility". We were tracking the Emulex-QLcc pair, so the following dayEmulex stayed well above the upper SB all daylong. At 3:50 pm, a spike in QLGC carried the spread below the SB, where 700 shares of EMLXwere shorted. Simultaneously, along position was taken in QLcc. Just two bars later on the following moming, the spread dropped below zero, and the spreadwas covered.

A trader might question why QLcc would rise so suddenly. The answer is that pricing disparities are created near and at the closing beU, as well as at the opening beU. Because ofthe artificiality ofthe moves, these times provide the best quick pair trading opportunities. Do not think about why the trade happened; just tske it because Icc does not apply here. The Iccal trader probably got caught leaning the wrong way.

Some ofthe most interesting pairs are composed of stocks that belong to a major market index such as the Nasdaq 100 or S&P 500. With the growth in index funds and exchaiige-tradedfimds (ETFsJ, moneymanagers are obligated to buy or sell the component stocks that compose the index. In the absence ofany news, an index stock cannot get too far out ofwhackbefore index bujing or selling brings the stock back into hne.

JC-Smin NASDQ

..It"

,...""""""" iy"4,....,..., ,...,----------------

DLGC-Smin NASDQ

----------",.A,-..

44.20

-43.80 43 00

Acme Spread(Clase of Data3,Clase

0.0000 0.0731 0.0000 .0731

12:20 13:00 l3.4Q 14:20 ISP

lyU 10 011 10 » SD 1 - 0 13:10

2.6.6 RF Micro Devices-TriQuint Semiconductor

In the irit of price anomalies, we want to exploit the moming reversals with pairs. When two stocks start moving in opposite directions, the spread chart will form aspike. The trader maybe thinking that if one stock in the pair goes up but the other does not, then that would be a perfect opportunity to short the rising stock and buj the other. In the absence ofnews, this may be a good idea, but remember that the stocks are moving this way for a re ason, and you will probably not know why.

In Figure 2.9, RFMD has moved up, but TQNT has not. The spread spikes above the SB and crosses below the line two bars later. This scenario fllushates the importance of waiting for a spread to reverse across the SB. Ifthe spread does not reverse, then the trader may consider a reverse spread strategj in the event of significant news.

Another way to confirm an "out of boimds" pair trade is to wait for either stock to reverse its tiend on a break ofthe high or the low. In the chart below, although the spread is above the upper SB, the trader may wait to short RFMD imtil it breaks the low ofthe previous bar, which it did not do imtil the fifth bar ofthe session. Similarly, he or she may wait to bujTQNT imtilit breaks above the previous high, exceeded on the sixth bar. Finally, the trader may want both conditions to occur before taking the pair trade.

ronr-IOmin NASDQ

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-16.50 17.50 -16.50 -0.250[

15-10 4 10:40 11:10 IJ 00 1Z:40 13.20 14:00 14.-40 IS 20 4 6

IlKii"- Kl Mil rn DiWs IVit >!,Lnl Si-mi.-.>n.lik Im I.i

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III. . I..,I .

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2 Pair Trading

2.7 Pair Trading Strategies

We keep an Excel spreadsheet of at least fifty correlated pairs for the Acme P System. Of course, the stock market has an almost infinite number of possible pairs, but trading this strategy requires both liquidity and volatility, making most of them infeasible. Filter out those stocks with little volume and low ATRs. The key is to find two competing stocks in the same industry satisfying these criteria. Following are some examples:

- Abgenix (ABGX:Nasdaq)-Medarex (MEDX:Nasdaq)

- Arch Coal (ACI:NYSE)-Massey Energy (MEE:NYSE) Allstate (ALL:NYSE)-Progressive (PGR:NYSE) Apache (APA:NYSE)-Anadarko Petroleum (APC:NYSE) Activision (ATVI:Nasdaq)-THQ Incorporated (THQI:Nasdaq) Altera (ALTR:Nasdaq)-Xilinx (XLNX:Nasdaq) BJs Wholesale Qub (BJ:NYSE)-Costco (COST:NYSE) Ballard Power (BLDP:Nasdaq)-FuelCell Energy (FCEL:Nasdaq) Citigroup (C:NYSE)-J.P. Morgan Chase (JPM:NYSE) Cate illa (CAT:NYSE)-IngersoU-Rand (IR:NYSE) Carnival (CCL:NYSE)-Royal Caribbean (RCLNYSE) Capital One (COF:NYSE)-Household International (HFNYSE) Calpine (CPN:NYSE)-Dynegy (DYN:NYSE) Centex (CTX:NYSE)-Lennar (LEN:NYSE)

Quest Diagnostics (DGX:NYSE)-Laboratory Corporation (LH:NYSE)

- DuPont Photomasks (DPMI:Nasdaq)-Photronics (PLAB:Nasdaq)

- EMC (EMC:NYSE)-Network Appliance (NTAP:Nasdaq)

- Emulex (EMLX:Nasdaq)-QLogic (QLGC:Nasdaq)

- Goldman Sachs (GS:NYSE)-Morgan Stanley (MWD:NYSE)

- Home Depot (HD:NYSE)-Lowes Companies (LOW:NYSE) Human Genome Sciences (HGSI:Nasdaq)-Millennium Pharmaceuticals (MLNMiNasdaq)

- Starwood Hotels (HOT:NYSE)-Marriott (MAR:NYSE)

- Internet Security Systems (ISSX:Nasdaq)-VeriSign (VRSN:Nasdaq)

- Jabil Circuit (JBLNYSE)-Sanmina (SANIVl:Nasdaq)

- Jones Apparel (JNY:NYSE)-Liz/ Clairborne (LIZ:NYSE) -I Mercury InlEiadi/e (MERQ:Nasdaq) Micromuse (MUSEiNasdaq)

- PeopleSoft(PSFT:Nasdaq)SiebelSystems(SEBL:Nasdaq)

2.7PairTrading Strategies

- RF Micro Devices (RFMD:Nasdaq)-TriQuint Semiconductor

(TQNT:Nasdaq)

- UnitedHealth Group (UNH:NYSE)-WellPoint Health (WLP:NYSE)

27.1 Tips and Techniques

1. When legging into a pair trade, initiate the short trade first to make sure you can get an uptick, unless you have a forward conversion or bullet that allows you to short without an uptick.

2. There are several alternatives for closing out a pair trade. Some traders prefer to close out all trades at the end of the trading day. Others prefer to let the spread go to the opposite spread band over a period of two to three days.

3. If one ofthe stocks in the pair trade has significant news, then the pair trade may not be feasible because the spread may widen dramatically; however, the system rules preclude entering a trade until the spread starts reverting to the mean.

4. Find stock pairs that fit the "leader-laggard" criterion within a specific industry niche. Do not settle on a general sector; look for stocks with products that directly compete with each other, e.g., two companies with a similar cancer drug.

5. For intraday pair trading, use as small a time frame as possible. The window of opportunity can be small, so three-minute and five-minute charts should be used. Another option is to change the Acme Spread indicator to alert the trader whenever either of the SBs is touched.

6. When assessing a potential stock pair, research its technical characteristics. The stocks should be bouncing around within the bands, not flat-lining. Look for spikes in the form ofthe letter "V". In contrast, some stock pairs are so correlated that they are not worth trading.

7. News is not necessarily bad for a pair trade-it can create opportunity. Unless the news is significant, the pair trade is a good option; otherwise, the reverse spread may be a better trade. Psychologically, this is a difficult type of trade but gets easier with experience.

8. We prefer morning trades around 10:30 am and afternoon trades around 2:30 pm because these times tend to be intraday reversal points in the market. Ifthe spread is still widening after 3 pm, then traders are probably caught the wrong way, and the spread will probably not reverse in time.



2 Pair Trading

9. Compare the performance of tlie system using todays open versus yesterdays close. Some stocks exhibit a tendency towards unusual gaps, and this usually improves pair trading performance.

10. To adapt the Acme P system to position pair trading, add a parameter that specifies the number of days to carry the position. Then, multiply this number by the Spread Band value to widen the bands. Finally, change the Pricel and Price2 parameters to reference the closing prices of N days ago.

11. We monitor all pairs with a set of TradeStation workspaces, six chart pairs per workspace. Note that running multiple workspaces with multiple charts requires extensive computing power; we recommend a dual processor machine.

3 Pattern Trading

Paranoia is the belief in a hidden order behind the visible.

Anonymous

Computer technology has changed the Zeitgeist of the market into a real-time information machine, sending multiple data sources flooding into a traders computer. Currently, raw data feeds supply primitive quote information. The next generation of data feeds will feed patterns into the computer, mining data on the fly to identity technical patterns that match the traders criteria.

A pattem combination system identifies charts with two or more patterns with a similar bias-bullish or bearish. If a chart shows both bullish and bearish qualities, then the bias is neutral. Essentially, the system catalogs all known bar patterns and then identifies combinations of them. Furthermore, the system is extensible. A trader can add as many patterns as possible, building the pattem catalog. For example, Dunnigan developed a swing-trading catalog of patterns that could be implemented in a pattern combination system [9].

The system is not limited to any particular style of chart. Every candlestick pattern has an analog that can be encoded in a normal bar chart [22, 23]. So, a Harami can be combined with a Gann pullback [18]. The exciting aspect ofthe Acme M system presented here is that the trader is free to invent his or her own patterns and plug them in. Design the pattern, code the pattern function, and call it from the Market Patterns model. As an illustration, we designed a sample bar pattern called a Cobra because ofits resemblance to a striking snake, with a head at the top and a tail at the bottom.

Non-technical information about a stock can also be encoded in a pattem. For example, a stock may have a quarterly eamings pattern cycle [13]; it may simply be the datefivedays before the companys earnings report. This eamings date may coincide with a pullback pattern, so fundamental information can be combined with technical information to ITCHto a trailing signal.

One issue facing the trader is the lack of access to a universal database. The trader should have a real time interface to fundamental data such as the stock



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