Saturday, October 4, 2008

Sector Trading: A Primer

One of my favorite setups is to watch an entire group of competing stocks. If there is a leader, you can watch the leader and trade the laggers to make a quick scalp. This makes money because of the existence of statistical arbitrageurs who keep a sector in line. 

Take the agricultural chemicals, for example: POT, MOS, AGU, TRA, CF, MON. Using a statistical technique known as a minimum spanning tree, we can establish POT as the "leader." AGU is the closest lagger behind POT. 

So in the beginning of the day, if POT is ripping you can buy a little AGU and have a positive expected value of your return; as long as POT keeps going you can book profit in AGU. The same works on the downside.

Do your own research; look at some good charts to verify what i'm saying. use some stats packages to establish a theoretical price for POT given AGU. the best approach is a combination of the two. 

-RiskAffine

4 comments:

david said...

do you Use a statistical technique known as a minimum spanning tree for all different sectors. Is there a program that can find this for other sectors?

Funny Circus Bears said...

If POT is "ripping" then buy it. What is the purpose of a proxy?

david said...

I understand that, but how could I find another "pot" lets say in oil. etc. is there a program I can run?

RiskAffine said...

@david: with 6 stocks you can do it manually; but for more you can download a free program like r-squared or a not free one s-plus (both based off same language) that have built in MST programs. another method is to "construct" a proxy by combining other stocks into a linear model (look up cointegration and trading)

@funny circus bears: if you think that buying pot whenever it goes up is a viable strategy, then by all means go for it. but thats not what we're talking about here. this strat uses the fact that we've established empirically a leader/lagger relationship that we are exploiting; we're using the information received from POT to trade AGU. If it looks as though AGU should be higher given POT, we buy. Same on the downside.