Friday, September 18, 2009

Gold Digger - Part 4

This post will conclude the Gold Digger series for now. I'm in the process of developing a few additional metrics and a graphical interface and may post in a week or so when finalized.
For now, I've added GLD to the matrix to demonstrate my argument for using NEM in lieu of GLD to trade gold.
In this case the hypothetical P&L for GLD versus the other components of the matrix is tracked vertically and the Linearity of correlation is tracked horizontally. That's in contrast to the way NEM is tracked and reflects the nature of the matrix.
One other feature of the matrix is the ability to build a basket portfolio by manually adjusting the filter threshold for Linearity. In this case I've entered 90% (red circle) which, in turn, highlights those returned values 90% or greater, and which can be added to the Optimized Portfolio list, saved and updated on a daily basis. This function lets us view the updated day-to-day performance of the so called "optimized" portfolio and allows us to cull under-performers and/or add new star performers.
Regarding yesterday's look at the Trade Reports for the XLE, DIG, ERX and NEM pairs I've shown the scatter diagrams of daily P&L for the XLE and ERX pairs to emphasize what you're buying when using ERX in lieu of XLE. Basically, you're buying risk.

The daily P&L tracker is not a resident report in the Trade Report, but Jeff has graciously given me limited access to the program source code so I can noodle around with it and produce little vignettes like these.
Note that the volatility surges mirror one another between the two reports. . for example 3/1, 6/1 and 9/1, but what's different is the total range of gain and drawdown. . . +10 to -10% for the XLE pair versus +20 to -20% for the ERX pair.
While there is some lag in signal timing of the XLE versus ERX pairs (as shown in yesterday's Trade Reports) the choice of a preferred pair ultimately revolves around the level of risk exposure you're willing to tolerate.

From that perspective, running a quick thumbnail matrix of various pair Betas, Linearities and P&Ls can deliver a comparative view of pair probabilities and anticpated risk exposure.
Running a Linearity filter can provide a performance baseline for evaluating the relative merits of each matrix pair.
And, maintaining a portfolio of filtered pairs while standing back from trades whose P&L falls below the R2 slope line can provide a nice revenue stream with controlled drawdown.
My intent for the next month or so is to profile one pair (and pair matrix) per week as part of an on-going refinement of my own pairs trading strategy. That post will be on Tuesday as Monday's are reserved for VIXology updates until further notice.
One final comment in response to a number of emails suggesting my past 2 weeks of REWIND related posts are just a big advertisement. They're not . . and I receive no $ from Jeff for profiling his Pairs Trader. I won't be vacationing at his chateau on the Cote d' Azur, cruising on his 125' super yacht, or partying with him at Cannes with Brad and Angelina.
I just think the program's a true winner, especially as a risk management tool and my intent over the past 2 weeks has been only to share my exploration and enthusiasm for the product.
Nuff said...............

1 comment:

QuantWizards said...

Well, you could come fishing with me on my kids' rubber raft Bob! Seriously, the full explanation is found on my blog and has been for a couple of years (search for 'pairs'), so conceivably anyone could replicate the program in Excel or any other program if they were so inclined. As I see it, it's a method of trading you are writing about, not a program per se. Best, Jeff