Hedging System

[findfreegold]

I am interested in experimenting with a system where two different stocks are selected that tend to follow the same trend closely. I would buy shares of one stock, and sell short on the other, and as soon as they made their move, I would either sell off to minimize loss, or buy to cover on the losing side, and let the winning side ride a few points. Question: Can anybody think of a good example of two different stocks that frequently take the same trend, and at the same time?
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I make handsome profits collecting free gold plated scrap and selling it for up to $100 per pound and more. Go to: http://www.findfreegold.bigstep.com

[nodoodahs]

I've found only one paper so far that delves into finding pairs that generally move together, and "long/short" them for arbitrage once they diverge. One would use a statistical analysis program to find the pair(s) in question and they would not necessarily be related in any other way. The paper is titled "Pairs Trading: performance of a relative value arbitrage rule" by Gatev, Goetzmann, and Rouwenhorst.

[edit added later: "one paper" that was purely technical-analysis-based. There are actually lots of references to pairs based on fundamental analysis. I should have been more clear when I first posted.]

There are relatively few references I've found to matching pairs specifically by industry, Henry mentioned it once and the Texas Hedge boys mentioned another time, it happens that TH was the first reference I read on it, making me think it might be more common than it is?

Most references I've found to long/short have been fundamentally-based systems that are performed irrespective of the sectors the stocks belong to.

Breakdown of stake:
+10% kept as cash reserve or margin requirement.
+89% is spent as purchases of long equities.
-89% is cash from sales of shorted stocks (note this cancels out the long purchases)
+89% is invested in T-Bills.
+ 1% is transaction costs.

Breakdown of return:
+ Interest income on the 10% cash reserve (if any)
+ T-Bill rate of return on 89% invested
+ Dividends paid on long purchases
- Dividends paid on shorted stocks
- Transaction costs
+/- Spread between long/short return

It isn’t necessary for the shorts to actually go down … they just have to go up more slowly than the longs do …

Is anyone on the board executing this strategy?

Can anyone point out what’s missing (if anything)?
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[nodoodahs]

If we go long an undervalued stock, and go short an overvalued stock, our return is based on our ability to judge valuation, and not on whether the overall market goes up or down. If those two stocks are in the same industry, then our return is neutral to whether that industry comes in or out of favor, as well. Our positions could be actual shorts and longs, or put and call options, whatever, just have equal dollar values in each side. This is sometimes called market-neutral, matched pairs, or short/long investing, although I have seen the term short/long used to describe the technique when the stocks are not necessarily in the same industry or correlated in any way.

If we review some fundamental or value based strategies, like that suggested in the link below, we have some tools to find stocks that have good or bad prospects based on fundamental analysis.
http://webuser.bus.umich.edu/Lundholm/mywebs/valuedog/Piotroski_Value%20Investing.pdf

A nimble trader could do this with overbought and oversold stocks, or use other technical indicators.

Texas Hedge wrote about a matched pair in the amusement park industry.
www.texashedge.com (see the Feb and Apr 2005 issues)

We bring Great Wolf to the attention of our readers knowing full well that not every one has or should have to desire to short or buy put options. However, we find it particularly intriguing in that it operates in the same general amusement park/hotel industry as one of our favorite companies Cedar Fair – perhaps setting up a nice pairs opportunity.

By going long FUN (15.9x next year’s earnings) one would clip a 6% tax deferred dividend and pick up a couple of percent in annual short rebate on WOLF (62x next year’s earnings) until the valuation gap collapses. This is a trade we would only advise institutional investors with strong stomachs to contemplate, but one with merit nonetheless.

This paper has more details on the general idea.
http://www.ssi-invest.com/WhitePaper/DionFriedland.PDF
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[HenryTo]

findfreegold,

Examples are abound in the stock market, such as the two leading companies in the same industry, for example. One such popular trade among hedge funds has been a pairing trade between Freddie Mac and Fannie Mae - where a hedge fund would go long the former and short the latter - with the idea that both are in the same industry (and thus the industry risks offset each other) but FNM is in more dire straits than FRE.

Let me know what else you are looking at. Have you read any of the popular trading system books such as "Trading for a Living," etc.?

http://www.tradingblox.com/tradingblox/library.htm

Best of luck,

Henry