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Major Final Presentation 9910103551

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Trading Strategies Implementation

Trading Strategies Implementation

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  • 1.  In finance, a trading strategy is a fixed plan that is designed to achieve a profitable return by going long or short in markets. The main reasons that a properly researched trading strategy helps are its verifiability, quantifiability, consistency, and objectivity
  • 2.  In economics and finance, arbitrage is 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. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For instance, an arbitrage is present when there is the opportunity to instantaneously buy low and sell high
  • 3. Long one asset against short another (buy the cheap one and sell the expensive one)  Mean-Reversion Strategy: Spread between two highly correlated assets tends to mean revert  Stock-Picking Strategy: Eliminates systematic market risk and capitalize on mispricing in stocks  This report focus on the mean-reversion strategy
  • 4.  In accounting and finance, equity is the residual value or interest of the most junior class of investors in assets, after all liabilities are paid; if liability exceeds assets, negative equity exists. In an accounting context, shareholders' equity (or stockholders' equity, shareholders' funds, shareholders' capital or similar terms) represents the remaining interest in the assets of a company, spread among individual shareholders of common or preferred stock; a negative shareholders' equity is often referred to as a positive shareholders' deficit.
  • 5.  A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is an imaginary portfolio of securities representing a particular market or a portion of it. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. Thus, the percentage change is more important than the actual numeric value.
  • 6.  A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.
  • 7.  Equity: 50 US stocks from different sectors: Technology, Industrials, Energy, Consumer Staples, Finances, Material, Healthcare  ETF: 13 ETFs replicating index in various countries: Dow Jones, Midcap Value, Midcap Growth, Brazil, Germany, UK, Australia.  Indices: 10 Major Indexes: DJIA, Nasdaq, S&P, DAX, CAC, STI, HSI, Nikkei, etc
  • 8. Search for profitable pairs for the implementation of pair-trading strategies using the method of cointegration  Establish a search process and search criteria  Explore various pair-trading strategies  Analyze results on various trading instruments, i.e. Stocks, ETF, Stock Indices
  • 9. Stationarity & Cointegration  Construct a mean-reverting spread through linear combination  Cointegrating factor (the hedge ratio) is determined by the Johansen method  Spread is checked to be stationary using the Augmented-Dicky-Fuller test
  • 10.  Pair-Trade Criteria  Factors suggesting suitable trading pairs include:  Length: Longest period showing significant evidence of mean reversion  t-statistic: More negative t-statistic signifying a more statistically significant evidence of mean reversion
  • 11. Trading pairs are determined from the search procedure using historical data recursively Identified trading pairs are back-tested using historical data to determine the cumulative profit  3 different trading strategies are employed on the 3 different classes of trading instruments
  • 12. Using calibrated hedge ratio & mean to trade without recalibration or rebalancing  Strategy - Buy when z < mean + 0.5 * sigma - Sell when z > mean + 0.5 * sigma  Intuition: Assumes mean reversion about the historical long-term mean exist
  • 13. Adopts a dynamic calibration of hedge ratio & mean for a window of every 10 trading days and used to trade for the next 10 trading days with rebalancing  Strategy - Buy when z < mean + 0.5 * sigma - Sell when z > mean + 0.5 * sigma  Intuition: Assumes mean reversion about a mean with stochastic drift exist
  • 14. Using calibrated hedge ratio to trade without recalibration or rebalancing  Strategy - Buy when zt < zt-1 + 0.5 * sigma - Sell when zt > zt-1 + 0.5 * sigma  Intuition: Assumes that mean reversion follows immediately after a price shock
  • 15. Trading Strategy I: Analysis  Spread is not mean reverting around the historical long-term mean.  A trading position is entered into and the position is held for prolonged period as there is no exit signal.  Not a feasible trading strategy.
  • 16. Trading Strategy II: Analysis  Shows a higher trading activity compared to Strategy I and is consistently profitable for the pairs analyzed.  Apparently the most appropriate pair-trading strategy for Equity.
  • 17. Trading Strategy III: Analysis  Displays inconsistent performance across the pairs analyzed. There is a possibility of huge profits as well as huge losses.  This implies that there is no specific reaction to price shocks for equity pair-trading.
  • 18. The pair trading search process is most easily applicable to Equity as there are more individual assets to compare and easier to arrive at profitable pairs.  Using the length and t-statistic of mean reversion from the search procedure is a useful indication of profitable pairs for trading.  Pair trading performance for ETF and Indices are more consistent as compared to that of Equity.
  • 19. Trading Strategy I is not an appropriate trading strategy for the classes of trading instruments analyzed as there exists a stochastic drift away from the historical long-term mean.  Trading Strategy II is the most appropriate trading strategy for Equity.  Trading Strategy II & III are equally appropriate for ETF pair trading.  Trading Strategy III is the most profitable trading strategy for Indices however Trading Strategy is appropriate as well.