October 2011 - missingSTEP Blog -

Monthly Archives: October 2011

Statistical Arbitrage

Oct 30

What is arbitrage trading? What is Statistical Arbitrage?

This post describes the arbitrage concept and examines statistical arbitrage, a trading and fund management methodology that is the core of Emerging Market Intrinsic (EMI)’s Arbitrage Trader Model used in Stock Arbitrage Trader for the iPad.

Arbitrage is described as the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.

To give a simple and hypothetical (and also almost impossible) example, if 1.00 Euro trades at $1.50 in London, and only $1.20 in New York that provides a clear arbitrage opportunity for investors/ traders, to buy Euros in New York and sell in London and make $0.30 on each dollar. A clear, risk-free, but also very rare window of opportunity, arbitrage chances are usually caught by machines or computers continuously observing millions of data points simultaneously.

More specifically, if professionals talk about stock arbitrage, they usually mean one of the two main trading strategies. These are:

➤ Stock arbitrage in different geographic markets for the same equity. If for example Toyota’s American Depository Receipts (ADRs) / or US-equivalent shares is trading at $75 in New York and at $68 in Tokyo (a discrepancy this wide is again almost impossible), that again provides an imbalance, and a profit opportunity for the trader to buy the equity in one geographic market and sell in another.

➤ Statistical arbitrage. In conventional or deterministic arbitrage (see the basic examples above), a sure profit can be obtained from being long some securities and short others. In statistical arbitrage, there is a statistical mispricing of one or more assets based on the expected value of these assets. In other words, statistical arbitrage conjectures statistical mispricings of price relationships that are true in expectation, in the long run when repeating a trading strategy.

The Stock Arbitrage Trader App uses a complex version of statistical arbitrage strategy. Also referred in the finance world as mean reversion, statistical arbitrage observes real-time data of market and stock movements and assumes that each instrument must revert to its own mean or normal characteristic.

To measure normalcy or characteristic, the methodology examines each instrument’s volatility. Volatility of a stock is composed of market volatility (systematic risk) plus idiosyncratic (firm-specific) risk. In today’s markets, market volatility or the systematic risk dominates short-term trading patterns of most equities.

σ²(i)=β²(i)σ²(M)+σ²(ei)
σ²(i)………. Total risk or volatility
β²(i)σ²(M)… Market risk
σ²(ei)……… Firm-specific risk

Based on real-time calculations and analysis of multi-factor inputs/ variables, the arbitrage model determines a characteristic (or a price range) at which the stock is assumed to be statistically fairly valued.

If the price falls below this dynamically changing range, the model sends a “buy” signal, if the price goes above this range it says “sell”, or if the real-time price is between these intervals then it signals a “hold” call.

By using rigorous statistical methodology, the model identifies non-random patterns in the behavior of equities.

Exploiting these inefficiencies allows earning exceptional returns with little risk.

Bullish Three Inside Up: X, INTC, T, SPWRA

Oct 30

Here are some stocks that were recognized as having a bullish three inside up pattern in the japanese candlestick scans section of our iPad app Daily Stocks.

X – United States Steel Corporation (NYSE) [Click Chart to Enlarge]

INTC – Intel Corporation (NASDAQ) [Click Chart to Enlarge]

T – AT&T Inc. (NYSE) [Click Chart to Enlarge]

SPWRA – SunPower Corporation (NASDAQ) [Click Chart to Enlarge]

Stocks that Closed Down at Least 2%

Oct 30

After a good week on the market, and a strong friday, it’s not only important to look at the stocks that performed well but also those that have taken a hit. Daily Stocks gives us a nice list of stocks that closed down at least 2%: [Click to Enlarge]

Stocks that are on our watchlist: [Click Ticker to See Chart]
STJ – St. Jude Medical, Inc. Common S (NYSE) -2.12%
PCP – Precision Castparts Corporation (NYSE) -2.73%
AON – Aon Corporation Common Stock (NYSE) -4.54%

Overextended Stocks: Overbought SMA 200

Oct 26

Here is a list of some Overextended Stocks, more specifically Overbought SMA 200, that you can find in our apps Smart Trading for the iPhone and Daily Stocks for the iPad. These are good to keep an eye on for a long-term outlook.

[Click Ticker to See Chart]
BIIB – Biogen Idec Inc 25.0% Above SMA 200
GR – Goodrich Corporation (The) Comm 24.1% Above SMA 200
VFC – V.F. Corporation Common Stock 21.1% Above SMA 200
GWW – W.W. Grainger, Inc. 14.5% Above SMA 200
BMY – Bristol-Myers Squibb Company 13.4% Above SMA 200
ORLY – O’Reilly Automotive, Inc. 13.1% Above SMA 200
AZO – AutoZone, Inc. Common Stock (AZO) 12.7% Above SMA 200
MCD – McDonald’s Corporation Common S 11.2% Above SMA 200
ED – Consolidated Edison, Inc. Commo 10.3% Above SMA 200

Psychological Factors Affecting Short-Term Stock Trading Part 2

Oct 26

This is the second installment of Psychological Factors Affecting Short-Term Stock Trading. Read the first installment here.

4. Fear

Fear is the emotion that stops us from doing things that might be too risky. In the right quantity, fear is obviously an emotion that we need, but when fear becomes too great we can be prevented from doing things that might be necessary. The main fear a trader has is that they are going to make a losing trade and lose money. This is a rational fear as no trader wants to lose money, but it is irrational if it prevents the trader from taking any trades in the first place.

As an example, a trader might make a losing trade, and then be too fearful to make the next trade, which of course can turn out to be a winning trade, and would have covered the previous loss. By letting the fear take control, the trader now has a net loss, even though a winning trade was available. The emotion of fear can be overcome by acknowledging that all successful traders have losing trades occasionally, but as long as they are less frequent than the winning trades, there is nothing to be afraid of as there will still be a net profit.

5. Greed

Greed is the opposite emotion to fear, in that it is the emotion that makes us do things we would not normally do. The right amount of greed is necessary because it gives us the motivation to work at something, but when we are too greedy we will start doing things even when we know that we should not. In trading, greed can make traders make random trades, or hold on to positions longer than their trading system dictates.

For example, if a trader is watching a market moving strongly upwards, the trader might be tempted to make a trade even though their trading system says not to. The trader has allowed the greed to take control, and more often than not in this scenario, they will be buying right at the end of the move and will have a losing trade. The emotion of greed can be overcome by testing and then trusting in your trading system, and knowing that if you follow it correctly, it will make a profit without taking every potential trade.

6. Making Up Trades

Possibly the most emotional time for a trader is when their profit is negative, and they are waiting for their next trade to come along. During this time they will be impatient and anxious, and they will be desperate to take their next trade in order to make back the money that they have lost. Most new traders (and also many experienced traders) will start taking trades that are not part of their trading system (known as making up a trade). As soon as this happens, their loss will increase, and will continue to do so until they realize what they are doing and correct their behavior.

7. Accepting Your Emotions

The solution to emotional trading is not to try and remove or control your emotions (good luck if you decide to try), but to develop character traits that allow you to control your response to your emotions. By developing a personality that counteracts your emotions you will be able to continue making logical decisions, even when your heart is pounding and sweat is streaming down your face.

Patience and discipline are vital personality traits for professional traders. Being patient allows you to wait for your next trade regardless of your current profit / loss, and being disciplined allows you to take only trades that are part of your trading system (not making up a trade). For some traders, the thought of losing money is enough to make them instantly patient and disciplined, but for others, the emotions are too strong, and they need to cultivate their patience and discipline.

8. Trading Log/Notebook

One method of learning how to be patient and discipline is to keep a detailed log of the best trades and worst trades for that particular day. At the end of the day (or week, or month), replay the trades, and try to learn the reasons why you made or lost money. If there are any differences, you should be able to determine what caused them, and hopefully know what you need to avoid the next time.

Another method of becoming patient and disciplined is to have absolute confidence in your trading style. Knowing that your trading system will make money over the long term can be enough to overcome the negative emotions that occur when you are experiencing a negative profit / loss.

9. Being Ready For The Inevitable (Losses)

Even when they make the right choices, every trader will experience losses. These losses can deplete P&Ls and serve as a source of stress for many traders. The extent of your losses will depend on many factors such as your trading system, your trade, other market factors, and, very importantly, how you handle the stress of losing money on a trade.

We should never ignore them, but we can control them. Investors Business Daily founder, William O’Neil, preached about the importance of cutting losses short when he said:

“Whether you’re a new or experienced investor, the hardest lesson to learn is that you’re simply not going to be right all the time. And if you don’t cut every loss quickly, sooner or later you’ll suffer some very large losses”

That’s why losses are called “the inevitable.” But losses can be minimized. In fact, they should be if you want to continue trading!

Potential Bearish Triangle Pattern

Oct 26

BAC – Bank of America Corp (NYSE): Potential bearish triangle pattern. To establish a short position, wait for the price to break below trendline.

[Click Chart to Enlarge]

NFLX Breaks Trendline

Oct 25

NFLX Netflix beats estimates but outlook dissapoints. Broke below long-term trendline and 200-day SMA.

[Click Chart to Enlarge]

Stocks Closing with 52-Week High

Oct 25

It was a great day on the market and the Dow Jones, Nasdaq, and S&P 500 all closed up. We generally like to take a look at the Performance scans in Daily Stocks on a day like this:

[Click Image to Enlarge]

Just by glancing at this screen you can see that the market did well, lots of stocks with 52 week highs, lots of stocks “Going Up Fast” and lots of stocks closed up at least 4%. We’ve pulled out for you 6 stocks that we found intriguing from the “52-Week Highs” Performance Scan:

SPG Simon Property Group, Inc (NYSE) Closed at $122.87 +2.17 1.80%
PCP Precision Castparts Corp. (NYSE) Closed at $173.14 +3.64 2.15%
MAT Mattel, Inc. (NASDAQ) Closed at $28.26 +0.57 2.06%
M Macy’s, Inc. (NYSE) Closed at $31.12 +1.28 4.29%
INTC Intel Corporation (NASDAQ) Closed at $24.59 +0.56 2.33% We chose INTC as a Stock to Watch twice last week 1) When approaching resistance lines 2) When breaking majore resistance lines
CMS CMS Energy Corporation (NYSE) Closed at $21.07 +0.10 0.48%

Stocks to Watch: ZOLL, CROX, IMMR

Oct 24

These stocks are trading at or close to long-term trendlines. Keep an eye on them.

ZOLL ZOLL Medical Corporation (NASDAQ)
CROX Crocs, Inc. (NASDAQ)
IMMRImmersion Corporation (NASDAQ)

ZOLL [Click Chart to Enlarge]

CROX [Click Chart to Enlarge]

IMMR [Click Chart to Enlarge]

Like these Stocks to Watch? Get notified instantly via RSS, email (see our sidebar to the right), or follow us on twitter.

Psychological Factors Affecting Short-Term Stock Trading Part 1

Oct 24

In this 2 part series we will go over some psychological factors that affect stock traders of all levels, but that generally plague short-term investors far worse than their long-term counterparts. Along with these psychological factors we will provide tips and habits that successful traders usually put to practice.

Know your Trading Environment, Like Knowing the Weather

Just like knowing the weather in a city that you are visiting, you should know how the market is for a position before you enter a trade. The weather is never exactly the same on any two days, the financial markets are never the same on any two days.

Statistical Arbitrage is an attempt to profit from pricing inefficiencies that are identified through the use of mathematical models.To make the most of statistical arbitrage as a tool, Stock Arbitrage Trader users need to use a combination of:

a) the arbitrage signals provided by the model

b) the current market conditions of the index and how it relates to other markets around the world

c) the market specifics for the particular stock they want to trade.

Consistency for a trader/investor is the most important aspect of trading success. Anybody can make money on any given day. This is not a respectable feat. The key to being a good trader is to become consistently profitable.

3 Key habits of successful traders are:

Stop loss- Know at what price to sell your stock before you enter the trade and stick to your rules. The most important aspect of trading is to limit ones losses. Stop-loss levels vary from system to system and from trader to trader. While some traders prefer historical intraday volatility (measured by standard deviation) levels of the traded stock (instrument), others prefer technicals levels such as resistance.

Some other investors/ traders have fixed stop-loss levels such as -5% of cost. While there is no magical solution to this, investors must have a stop-loss level in mind and stick to that level. Also traders must shift stop-loss levels upwards as their long stocks go up in price and vice versa for short trades.

Do not marry your stocks- Just because you made money in a stock once, this does not mean that you will make money in that stock ever again. Stop trading a certain stock when you stop making consistent money with it.

Do not get too greedy- If you reach your goals for a particular day or month, take it easy. You can keep trading but the more you trade, the more you might incur losses on trades. An attempt to continuously defend a positive outcome is always dangerous as it negatively impacts human psychology.

Psychological Factors:

Some of the main psychological factors affecting a traders success can be summarized as patience, decisiveness, calm, fear, greed, making up the trades, accepting emotions, trading log, and being ready for the inevitable outcomes.

1. Patience

When non-traders imagine traders, many people think of them in a trading pit, wearing brightly colored jackets, shouting and waving their arms about. While this may have been true once, it is no longer an accurate image of trading. Modern trading is performed by sitting quietly in front of a computer, waiting anywhere from a few minutes, to several hours, or even days, for the next trade to come along.

Being able to wait patiently is a necessity, otherwise you will find yourself taking trades that are not part of your trading system (known as making up a trade), and most likely losing money on them. Waiting patiently does not necessarily mean doing nothing, and there are many things that you can do while you are waiting for your next trade, like analyzing financials, looking at charts, reading reports, etc.

2. Decisiveness

Deciding when to enter and exit trades is one of the most basic functions of a successful trader, and it is important that these decisions are made as efficiently as possible. Being decisive is vital to successful trading, otherwise you will only sit and watch trades that you should have actually taken. Being decisive does not mean being rash, and taking trades that you are not sure about, but it does mean acting promptly when a trade does come along.

A common pitfall that many beginners come across is seeing a trade happening, but hesitating and waiting for the trade to start moving into profit before entering (waiting for confirmation that the trade is going to be a winning trade before they enter it). This always results in an entry price that is not as good as it would have been with a prompt entry, and can turn a winning trade into a losing trade.

“Find a good entry price for a stock and don’t hesitate when it gets there”

3. Calm

Remaining calm during trading is one of the most important personality traits for a successful trader, but it is also one of the most difficult to obtain and practice. As humans, the natural reactions to a winning trade are excitement and joy, and the natural reactions to a losing trade are panic and sadness. However, traders need to control these emotions; otherwise they will adversely affect their trading decisions (particularly the negative emotions). For example, the panic that occurs after a losing trade might make you take a new trade almost immediately in an attempt to make the money back, even though there was no trade according to your trading system.

“If you lose a lot of money on a trade, take a water break, walk around for a little while, and regroup before you make another trade”

Part 2 of Psychological Factors Affecting Short-Term STock Trading. Get notified via RSS, email (see our sidebar to the right), or follow us on twitter.

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