Thursday, December 24, 2009

Selecting tradeable pairs: which measure to use?

A guest blog by Paul Farrington

One of the most important factors in statistical arbitrage pairs trading is the selection of the paired instruments.  We can use basic heuristics to guide us, such as grouping stocks by industry in the anticipation that stocks with similar fundamental characteristics will share factor risk and tend to exhibit co-movement.  But this still leaves us with potentially thousands of combinations.  There are some statistical techniques we can use to quantify the tradeability of a pair: one approach is to calculate the correlation coefficient of each pair's return series. Another is to consider cointegration measures on the ratio of the prices, to see if it remains stationary over time.

In this article I briefly summarise the alternative approaches and apply them to a universe of stock pairs in the oil and gas industry.  To measure how effective each measure is in real world trading, I back test the pairs using a simple means reversion system, then regress the generated win rate against the statistical results.  Some basic insights emerge as to the effectiveness of correlation and cointegration as tools for selecting candidate pairs.

Please visit for details of my methodology and results.

Friday, December 18, 2009

Public service announcements for quants

   1.  Conference on 'Computational Topics in Finance', February 19/20, 2010, National University of Singapore. The topics will include using R/Rmetrics in finance, but the conference is by no means confined to R. See

   2.  Consulting position (6-month renewable contract) available at a major Canadian bank in Toronto:  research in  various mathematical algorithms used for pricing of interest rate derivative instruments like swaps, caps, swaptions, FRAs. Please contact their recruiter at

   3.  A free copy of Chapter 8 of "High Probability ETF Trading" which I mentioned here is now available for download.

Sunday, December 06, 2009

Are financial speculations really "harmful human activities"?

It is worrisome when not one but two eminent economists denounced financial speculation as "harmful human activities" in the short space of 2 weeks. (See Paul Krugman's column here and Robert Frank's here.) It is more worrisome when their proposed cure to this evil is to apply a financial transaction tax to all financial transactions.

Granted, you can always find this or that situation when financial speculation did cause harm. Maybe speculation did cause the housing bubble. Maybe speculation did cause an energy price bubble. In the same vein, you can also argue that driving is a harmful human activity because cars did cause a few horrific traffic accidents.

No, we can't focus on a few catastrophes if we were to argue that financial speculation is harmful. We have to focus on whether it is harmful on average. And on this point, I haven't seen our eminent economists present any scientific evidence. On the other hand, as an ex-physicist and an Einstein-devotee, I can imagine some  thought experiments (or gedankenexperiment as Einstein would call them), where I can illustrate how the absence of financial speculation can clearly be detrimental to the interests of the much-beloved long-term investors. To make a point, a gedankenexperiment is usually constructed so that the conditions are extreme and unrealistic. So here I will assume that the financial transaction tax is so onerous that no hedge funds and other short-term traders exist anymore.

Gedankenexperiment A: Ms. Smith just received a bonus from her job and would like to buy one of her favorite stocks in her retirement account. Unfortunately, on the day she placed her order, a major mutual fund was rebalancing its portfolio and had also decided to shift assets into that stock. In the absence of hedge funds and other speculators selling or even shorting this stock, the price of that stock went up 40% from the day before. Not knowing that the cause of this spike was a temporary liquidity squeeze, and afraid that she would have to pay even more in the future, Ms. Smith paid the ask price and bought the stock that day. A week later, the stock price fell 45% from the peak after the mutual fund buying subsided. Ms. Smith was mortified.

Gedankenexperiment B: Mr. Smith decided that the stock market is much too volatile (due to the lack of speculators!) and opted to invest his savings into mutual funds instead. He took a look at his favorite mutual fund's performance, and unfortunately, its recent performance seemed to be quite a few notches below its historical average. The fund manager explained on her website that since her fund derived its superior performance from rapidly liquidating holdings in companies that announced poor earnings, the absence of liquidity in the stock market often forced her to sell into an abyss. Disgusted, Mr. Smith opted to keep his savings in his savings account.

Of course, our economists will say that the tax is not so onerous that it will deprive the market of all speculators (only the bad ones!?). But has anyone studied if we impose 1 unit of tax, how many units of liquidity in the marketplace will be drained, and in turn, how many additional units of transaction costs (which include implicit costs due to the increased volatility of securities) would be borne by an average investor, who may not have the luxury of submitting a limit order and waiting for the order to be filled?