Monday, October 27, 2008

GE / QQQQ Trade - Part 2

This post is a continuation of the GE/QQQQ trade post on Thursday.
Above the ratio GE and QQQQ chart. That nice horizontal line of the 20 and 50 DSMAs is a clue that this correlated pair trade has good potential. A lot of volatility off the mean to be sure, but for daytraders this is a good thing. If you run a ratio study of GE against DIA, IWM or SPY, you'll see why the Qs are the best correlated index to use.
A couple background facts to keep in mind:
GE is almost always in the top 10 volume of listed stocks.
GE typically trades 30-40% of Qs volume, although a recent downgrade by Zacks to "strong sell" has probably inflated the already substantial sell momentum.
GE is a favorite with several large prop shops, both as a pairs trade (not necessarily with the Qs) and as a stand alone daytrade. The prop shops typically hit it hard at the open and the close, when they can scalp the first and last few minutes of the trading day with mean reversion trades. This means lots of liquidity and lots of support for the mean reversion approach. A word of caution, however: the prop shops have very sophisticated program trading algorithms that execute automatically, so the open/close trades are not recommended for the average retail trader, as your odds of becoming cannon fodder for the prop shops is pretty high.
Although I mentioned the idea of a GE/QQQQ pairs trade in Thursday post, for practical purposes I wouldn't (and don't) trade it that way. I just trade the GE side. So how do you trade it? Well, here's one approach.
Above is Friday morning's chart of GE with the Qs shown as the gray overlay.
Since these 2 track together in the larger timeframe, the goal is to capitalize on short term divergences. The orange lines identify 2 divergences in slope during the morning session. It is at the point when the Qs are still trending up and GE reverses from a short term downslope that the high probability trades set up, which are shown as the small orange ellipses.
This is the same chart as above, but pulled back a little bit to show how GE and the Qs performed after the trade entries. You can also notice that when the Qs reversed momentum (slope) at 11:00 and 11:45, these were great exit signals for the GE long positions . . and a general risk management rule for this trade is to use a trend reversal in the Qs as an exit stop.

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