Alpha Trading: Profitable Strategies That Remove Directional Risk

Preface ix

Chapter 1 Uncertainty 1

Impact on Trading 2

The Inevitable Price Shocks 3

Why So Much about Price Shocks? 9

Complexity and Contagion Risk 10

The Ugly Side 11

Taking Defensive Action 11

Accepting Performance for What it is 13

Chapter 2 The Importance of Price Noise 15

Noise Explained 15

Different Markets 19

A Closer Look at Equity Index Markets 21

Importance of Noise 22

Determining the Strategy 25

Capitalizing on the Trend of Noise 29

Chapter 3 Pairs Trading: Understanding the Process 31

The Process 32

The Basics 32

Target Volatility 54

Home Builders 65

Using ETFs 78

Portfolio of Home Builder Pairs 84

Execution and the Part-Time Trader 89

Stop-Losses 89

Trading Intraday 90

Key Points to Remember 90

Chapter 4 Pairs Trading Using Futures 93

Futures 94

Mechanics of a Pairs Trade in Futures 97

Inflation Scares 100

Trading Energy Pairs 102

Revisiting Momentum with Energy Markets 105

A Miniportfolio of Natural Gas Pairs 112

The Inflation Pairs: Crude, the EURUSD, and Gold 119

Equity Index Pairs 128

Leveraging with Futures 138

London Metals Exchange Pairs 141

Volatility Filters 153

Interest Rate Futures 154

Summary 154

Chapter 5 Risk-Adjusted Spreads 155

Dell and Hewlett-Packard 155

Trading Both Long-Term (Hedged) Trends and Short-Term Mean Reversion 159

Gold, Platinum, and Silver 161

The Platinum/Gold Ratio 163

Implied Yield 170

The Yield Curve 174

Trend Trading of London Metal Exchange Pairs 179

Summary 184

Chapter 6 Cross-Market Trading and the Stress Indicator 187

The Crossover Trade 188

The Stress Indicator 189

Gold, Copper, and Platinum 195

Mining Companies 198

Agribusiness Pairs 206

The Major Energy Producers 208

Portfolio of Cross-Market Energy Pairs 220

Other Opportunities 226

Some Final Notes 228

Chapter 7 Revisiting Pairs Using the Stress Indicator 229

Futures Markets and the Stress Indicator 229

Equity Index Futures 230

Interest Rate Futures 238

The Portfolio Spreadsheet 245

Summary of Pairs Trading 248

Chapter 8 Traditional Market-Neutral Trading 249

Home Builders 250

Trend or Mean Reversion? 250

Basic Market-Neutral Concept 251

Volatility-Adjusting the Position Size 264

Arbing the Dow: A Large-Scale Program 267

Thoughts about Market-Neutral Trend Following 274

Market Neutral Using Futures 274

Market-Neutral Comments 277

Chapter 9 Other Stat-Arb Methods 281

Trade-Offs 282

System Briefs 282

New Highs and New Lows 290

Merger Arb 290

Creating Your Own Index Arbitrage 292

Arbing the Dow 301

Arbing the S&P 500—Index Arbitrage 302

About the Companion Web Site 305

About the Author 306

Index 307