“It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges. That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmorton Street is, compared with Wall Street to the average American, inaccessible and very expensive”
Times change and when JM Keynes wrote that in The General Theory of Employment, Interest and Money he did not anticipate the rise of bookmakers like William Hill, Ladbrokes, BetFair/Paddy Power and so forth.
Combined with the power of the internet and idiot-proof betting and trading algos (which is not a comment on the effectiveness of those same algos) the share prices of these companies came to bear an uncanny resemblance to that of the London Stock Exchange (LSE).
Here, for example, is a plot of the William Hill (in red) vs LSE share price between April 2009 and July 2013:
Very positive correlation (and strong cointegration too). It brings to mind the the more famous casino quote from chapter 12 of The General Theory:
“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done”
What, then, to make of the same graphic (with LSE now in red) since August 2013?
Now they show negative correlation (but still strong cointegration).
It is perhaps a sector comment and nothing more. But given that the DNA of the modern bookmaker is now part-bourse (they take financial wagers in addition to bets on just about anything else) it gives pause for thought on the possible future direction of the broader market.
After all, central bank actions have not bestowed identical benefits on the clients of bookmakers and on those of stock markets.
One of the most puzzling things about a long/short trade, crafted with hard cointegration-based analysis, fundamental data, sentiment assessment et cetera, can be to see its spread revert to its mean at a loss.
How can that be possible? Cointegration is supposed to identify enduring economic relationships, is it not?
Well, there are several losing paths where the theory of Mr Profit meets Mr. Reality (and comes off the worse). For example:
- The spread distribution underlying the Z score chart is not near-normal. Z scores rely on normality or near normality to be meaningful.
- The live beta deviates during the trade from the modeled historic beta. That may be due to a disturbance to the underlying cointegrated relationship – i.e. conditions are changing. This is common in FX where there are macroeconomic announcements nearly every day that are more signal than noise and can break cointegrated pairs – especially at the intraday level.
- The beta is unreliable due to a low R² (a measure of model strength). We find R²s less than 70% have a higher likelihood of failing to revert with profit.
Keep in mind, too, that many strategies typically rely on Z score triggers. Yet a Z is only a description of the spread – it is not an indicator of cointegration. If it blows out it may be reflecting a weakening cointegration situation; or it might be reflecting a small sample size (if one was used for the Z calculation) making it more sensitive to the incoming price data.
These types of scenario are the main reason ArbMaker software integrates “dynamic filters” into its Tracker allowing stops to be set based on the mean reversion coefficient, R², degree of cointegration and so forth. These are measures of and/or prerequisites for cointegration and will pick up direct changes to the underlying relationship better than a stop on the Z alone.
All the selections of our newsletter service use strategies that make allowance for this information. We strongly suggest users of our software take a similar approach!
What are the differences between trading long/short using equities as opposed to using what are called CFDs?
CFD is the abbreviation for ‘contract for difference’. It’s an instrument invented in the UK and behaves somewhat like a swap. Our trading account focuses on equity CFDs from Interactive Brokers (IB). The IB site has useful explanatory notes on CFDs here and a short video from them is below.
The key points of interest for our strategic approach are:
- CFDs offer around twice the leverage of equity margin on a long/short trade
- Suitable mainly for shorter trade horizons due to financing costs
- No expiry date like options
- CFD leverage works well with a hedged strategy
- IB’s CFDs exactly mirror the underlying equity spread (which is far from the case with other CFD brokers)
- IB has very low commissions for a frequent trading approach like ours.
- Unavailable in some jurisdictions including the USA. Dodd-Frank Act legislation considers and regulates them as swaps.
Our experience and data show that equity-only trading under our approach beats benchmarks and broad market gauges. CFDs simply magnify that performance further.
Our research service has begun 2017 strongly. Profit since inception last June sits at 22.6% for equity CFDs and 9.9% for equities. That is comfortably ahead of benchmarks.
Cut by sector profit performance looks like this:
The negative performance in Industrials is due to the effect of the Trump Bump on transportation shorts held in early November.
The first edition of our 2017 newsletter is out today! +18.9% in 2016. Snippet below, try a copy here.
Our research partner shares their 2016 performance using ArbMaker software.
Read the full 2016 report here.
Our research partner put in a stellar 2016 performance!
To read more get the full report here.
A Trump presidency, financially speaking, portents huge change. Maybe.
The bond market thinks it’s a definite maybe – US 10 years Treasuries have sold off the most sharply since 1991! This is no less than the end of the “new normal” being priced in.
The “new, new normal” currently anticipated is this:
- Fiscal policy in
- US stocks in
- US growth in
- Emerging markets out
This opens up significant opportunities for a new set of long/short, relative value trades.Some areas of interest to consider carefully:
- Leverage. Rates to rise on fiscal expansion suggests companies with more leverage face revised growth estimates. But in which direction? Macro growth plus leverage often equals out-performance. But consider the markets where the growth may not come or is patchy – including President-elect Trump’s own commercial real estate sector where maturity schedules coinciding with rate rises may be painful.
- Exports. A stronger dollar plus higher bond yields in the US is not great for emerging markets. Factor in potential tariffs, walls and quotas and it looks worse still. Take Mexico for example. Kansas City Southern railroad fell heavily on the election result given it generates nearly half its revenue from US-Mexico trade. If you believe that is a durable position it may be worth looking at why, since Mexico is the largest buyer of US corn, there has been a negligible impact of (presumably) lower animal feed costs on US companies like Tyson, Pilgrim’s Pride and Sanderson.
- Rotation. If fiscal expansion equals growth and that is why US Treasuries are selling off so dramatically it is worth asking why high dividend stocks are holding up so well. Rising bond yields should be hurting a lot more than they are.
- Energy. There are interesting opportunities between US oil producers and a variety of energy consuming industries. President Trump’s anti-OPEC rhetoric and pro-drilling policies state-side make it very hard to envisage any crude price increase manufactured by OPEC sticking. Traditional automotive, transport, travel (to mention but a few) are all potential beneficiaries.
These ideas, and others, can of course be tested under ArbMaker (see this video for more on how).
The Premium Newsletter has now covered 28 paired trades since inception. A comparative performance chart against the S&P 500 is below.
- We trade every idea and flash alert sent to subscribers in our own real-money Interactive Brokers account
- Pair win rate of 79%; leg win rate of 64%
- Positively skewed distribution of returns
- Low correlation versus the S&P 500
- Absolute returns to date compared to a negative S&P 500
- Max equity drawdown of 2.45% (vs 4.35% for the S&P 500)
- Max CFD drawdown of 6.21%
- Real time alerts for all our trades
It is an attractive profile and one you can follow without obligation for a month.
Of the inquiries we receive about both the software and our research service are several related to trading philosophy. We address this regularly in our newsletter service for it is a large topic. Here’s an excerpt from today’s edition to be dispatched to subscribers at 10h00 GMT.
“Some definitions, particularly for newer clients, behind what we do under the banners of ‘equity long/short’ and ‘relative value’.
While hedge fund strategy definitions tend to be fluid it is reasonable to say that pure equity long/short is about stock picking. The long and short securities are not necessarily related. Frequently the overarching portfolio goal is to provide the flexibility to be positive, negative or neutral in terms of market beta.
Pairs trading is a variant of this but seeks to match-up similar securities. And statistical arbitrage is the snooty relation to pairs trading.
Where the traded instruments come from a broader universe of financial assets than equities alone (CFDs, for example), ‘long/short’ tends to be called relative value trading.
Clearly there is much overlap here. This newsletter aims to be pragmatic and forms its trades across what is in reality a broad church of strategies.
Economic substitutes, near substitutes and securities linked by common factors (usually macroeconomic) interest us the most. Statistical substitutes are typically of least interest.”
‘Pragmatic’ is perhaps the most important word in there. Experience and new academic research sometimes offers up new information that needs to be wheated and chaffed; and in this sense a trading methodology may have the characteristics of an evolving framework!