RelativeValues Lab principles

In today’s post, we are going to look at how the research application’s outputs become a custom application.

The application is planned to be divided into individual modules for each trading approach. Each module will have formalized output defined by given trading strategy: backtest and detailed analysis (with charts and metrics). The user can create own strategy by chosen input parameters.

One of mentioned trading approaches is Relative value, what is based on bets on convergence when the discrepancy between similar or same stocks widens. It means searching for opportunity to exploit from gaps in the price or rate of the same or similar securities. It supposes that the differences are only short-term and the rate of the prices will revert back to original (normal) ratio soon. Relative value funds are perceived as hedge funds as they do not trade the price of a specific security alone and the policy of benefitting from the pricing discrepancies is to buy one security (considered undervalued) and sell the other (considered overvalued) in a form of pairs trading.

The user (fund manager) will build this kind of trading strategy in some basic steps:

• selection of suitable pairs
• identification of situations leading to do trading actions

According to this universal framework, a lot of questions will rise and the application should allow the fund manager to solve them.

No doubt that the phase of suitable pairs selection is crucial. Potential fund manager has to find two stocks that are similar enough. In the data preparation step of the analysis it is necessary to solve problems like:

• what historical period to consider for pairs selection
• what indicators (technical, fundamental etc.) and what role will they play in the similarity detection, e.g. find assets what have moved together historically
• determine what to consider as normal differences (the similarity)
• what to do with pairs where the assets are too similar (nearly the same) in considered indicators (it will probably generate no arbitrage opportunity)
• which assets according to some (fundamental, technical etc.) factors to select or filter out from consideration

Next step in the pairs selection process is to do the proper analysis of prepared data. Here the questions are mainly:

• what approach or algorithm to use for similarity calculation – widely known and used are cointegration, correlation, regression etc.
• evaluate the pair robustness/power (total, in various periods)
• determine strictness of condition for pair identification
• how many pairs minimally is suitable to have in portfolio
• what to do with assets that take part in more pairs
• what role can play the upcoming fundamental events (fusion, bankruptcy etc.) in identified pair stability

After the crucial step of pairs selection the trading part of the strategy follows. It deals with determination of trading signals, e.g. define rules solving problems like:

• how much the assets in the pair should differ for opening the positions
• are there other relevant indicators disproving suitability of opening the planned position (long position planned and the RSI shows the overheated asset etc.)
• determine the ratio of assets in open positions
• what dissimilarity of assets should lead to close the positions
• how long to wait maximally for the spread returning to normal state or for closing the positions regardless to trade result (avoiding possible higher losses)

Naďa Chalupová