Stock Timing

Using Pairs Logic

Perry Kaufman
www.kaufmansignals.com
 A commercial break for KaufmanSignals.com

• The strategy shown here is one of three available on

KaufmanSignals.com
• The strategies are fully disclosed.
• Two of the strategies apply to stocks, ETFs, and
futures. This one applies only to stocks and ETFs.
• Today’s presentation is a slightly simplified version of
the full program, but is excellent as is.
• You can receive a working (not protected)
TradeStation program on request.
• The website takes this strategy further, creating
dynamic portfolios and processing a large list of
stocks and ETFs. The essence will be explained here.
 It’s based on arbitrage
• Arbitrage is one of the great strategies of all time.

• In “pairs trading” it finds two similar markets that are

moving apart, then buys the cheaper and sells the more
expensive, exiting when the come back together.

• It can be done with U.S. – London – Hong Kong gold, or

Ford – GM – Toyota – Honda, or Pulte and KB Homes, or
even U.S. 10-year notes and the Eurobund.

• With new technology it’s easier but more competitive.

 Traditional Approach
To identify trading opportunities, we can
1. Find two stocks (or ETFs or Futures markets) with
correlations between 0.30 and 0.80 (not too strong or
too weak)
2. Then use the ratio (or difference) of two prices to find
overbought and oversold points

Or
Use cointegeration (the real method) to decide if these
two stocks move in generally the same direction.

But we won’t. It’s unnecessarily complicated.

We’ll use the Stress Indicator that I introduced in “Alpha
Trading”
Example: Ford(top) v GM(middle) using the ratio (bottom)
• Buy Ford and sell GM when ratio is low
• But what is high and what is low? And what is “normal?”
• Each pair has a different ratio so we can’t generalize what value is
overbought or oversold
 Using the Stress Indicator
• The Stress Indicator is made up of 3 simple stochastic
calculations (“raw stochastic”), over a 60-day period
• The stochastic is important because it doesn’t lag
• Stochastic 1 (F) = (C(today) – L(60))/(H(60) – L(60))
• Stochastic 2 (GM) = (C(today) – L(60))/(H(60) – L(60))
• Stochastic difference (D)
D = Stochastic1 – Stochastic2
• Stress = (D(today) – L(60)) / (H(60) – L(60))

• Ford is oversold relative to GM when the Stress Indicator

is below 10 (used as an entry). We will buy there.
• It is neutral at 50. We exit there.
F v GM using the Stress Indicator
(Stress=3rd panel, stock stochastics at bottom, signals top panel)
 Good, but not good enough
The Stress Indicator gives good buy and sell points (under
10, over 90,), but buying one stock and selling another has
problems:
1. Profits are frequent but very small (a lot of competition
and similarity of price movement), often about 3¢/share
and you need to trade a large size to offset costs.
2. It may be difficult to execute the short sale
3. Short sales aren’t allowed in IRAs.

One alternative is to sell the SP (or buy SH or SDS) rather

than the other stock, but then profits are even smaller
because the index does not move as far (not as volatile) as
an individual stock.
 If you look hard enough…

• If you study the performance of the pairs, the long

position is the one that always makes money
• The stock market has a very strong bias to the
upside
• Even when the market declines, it is fast, and the
upward climb occurs most of the time, to different
degrees.
• Then we really want to buy the stock but not go
short against it. Our profits per share would be much
bigger, more than 30¢ instead of closer to 3¢.
 Traditional results of AMZN-WMT pairs
trade using Stress Indicator
$P/L AMZN-WMT Pairs trade
2000

1500

1000

AMZN
500
WMT
cumPL
0

-500

-1000
3/1/2005 3/1/2006 3/1/2007 3/1/2008 3/1/2009 3/1/2010 3/1/2011 3/1/2012 3/1/2013
Typical results of separating longs and shorts –
a better pattern and larger returns/share
Taking only the long trades for Taking only the short trades for
AMZN-WMT AMZN-WMT
1400
800
1200
600
1000
400
800

600 200

400 0
200
-200
0
-400
-200

-400 -600

-600 -800

Long AMZN Long WMT Total Long

Short AMZN Short WMT Total Short
 0
100
200
300
400
600
700

500

-200
-100
3/1/2005
7/1/2005
11/1/2005
3/1/2006
7/1/2006
11/1/2006
3/1/2007
7/1/2007
11/1/2007
3/1/2008
7/1/2008
11/1/2008
3/1/2009
7/1/2009
11/1/2009
3/1/2010
7/1/2010
11/1/2010
3/1/2011
7/1/2011
11/1/2011
3/1/2012
7/1/2012
11/1/2012
Apple v SPY ($PL) – the early loss in AAPL is

SPY
Total
AAPL
easier to take than the loss in SPY (better with QQQ)
Apple trading signals
Stress in red at bottom
 Returns per share in $

0.5
1.5

-0.5
0
1

-1

0
1
2
3
4
5

-4
-3
-2
-1
AAPL Symbol
TM OXY
IBM CAM
APC GIS
BIDU TLM
AMGN MT
EOG SLB
APD NE
C EOG
DVN BAX
ATI WMB
ESV APD
CCL HAL
BAX BIDU
PEP NEM
MT RS
SRCL CLF
NFLX SNY
MSI BHI
HES DVN
ABC SE
XLNX TS
HD MRO
ABX CVX
MON MON
RS ADI
DE HES
GIS CSX
GGB K
K TSM
GILD VE
AA UNP
PKX QCOM
TOL DE
FTI HUM
DAR CPB
DUK CAT
ARMH GTAT
TJX LEN
NOC M
GPC MTU
BMY PKX
TGT NOC
UNH HSY
ETR NEE
CLX ALK
CVS TGT
AEP AEP
profits per share

TXN PCG
KMB JNJ
SYMC KMB
GPS ETR
MCD CCC
RAI ITW
RSG MO
CNP ALXN
AAMRQ SBUX
CAG NSC
UAL YUM
ED LCC
Return ratio of 218 long stock positions (65% profitable after $8 cost)

WM WM
PSA NVS
SPWR SPWR
NVS GM
Profits per share 218 long stock positions (FB is on the right), $0.30 median return

AFL VZ
KEY KO
HA BRCM
SCHW KEY
DD GE
SEE PAYX
Overview of results – information ratio and

PAYX SEE
BAC JBLU
MRK WFC
 Not all stocks work
• When you arb against the S&P (or QQQ, IWM) not
all stocks work
• Some don’t track with the index because they may
not move with the economy in the same way
• For example, during the crisis of 9/11/2001 the
market plummeted – except for defense stocks,
which went up – Raytheon (RTN) jumped 100% from
9/10 to 9/28 – if we’d only known!
• Trying to figure out (fundamentally or intellectually)
which work and which do not is a useless exercise
• Running the strategy against each stock and using
the one’s that work is much easier and just a valid
 But we can’t trade
without risk protection

• What if we have another 2008 and we’re sitting with

a long portfolio while the market tanks?

• What if we are long Enron or another company that

just collapses?
 Protecting the downturn
• Unfortunately, it’s not safe to always be long
• We can protect our long stock positions by selling SPY (or
buying SH or SDS) when the trend of the index turns
down (or selling QQQ or buying QID)
• In our simple version we use a 60-day moving average
and hedge 50% of the risk when that trend turns down.
• In the full version we use 3 trends, 30, 60, and 120 and
hedge 1/3 of our 50% hedge on each trend.
• The amount of the hedge is:
Stock size x (20-day ATR of the stock price divided by the
20-day ATR of the SPY price)
• The total hedge size is the sum of the hedge amounts for
all the open stock trades
• Add and remove hedges as your positions change or
when the trend of the hedge index changes.
Protection Using the Trend of SPY
Only take long stock positions and sell SPY
when the SPY trend is down (center panel)
Risk calculation using 3 stocks
SPY hedge size
 Stop-loss
• I hate stop-loss orders, but they are necessary in this
strategy
• If we are long and we’ve picked an Enron, the price can
keep falling while the SPY is still in an uptrend
• Then we would never exit the trade because it is always
oversold compared to the SPY
• We never hedge because the overall market is still in an
uptrend
• Therefore, we use a 15% price stop from the point of
entry, just for an emergency
• In the long run, no stop is best, but in the short run, an
Enron can end your trading career
 Sample good results
AMZN v QQQ AMZN v QQQ
Total $P/L Number of Shares Traded
12000 400

300
10000

200
8000

100
6000

0
4000

-100

2000
-200

0
-300

-2000
-400

StockPL IndexPL CombPL

Long AMZN Short QQQ
 More good results
HES v SPY Total $P/L HES v SPY Number of Shares Traded
400
6000

5000 300

4000 200

3000
100

2000
0
1000
-100
0

-200
-1000

-2000 -300

-3000 -400

StockPL IndexPL CombPL Long HES Short SPY

 Other results
AFL v SPY Total $P/L AET (Aetna) v SPY
2500
12000

2000
10000

1500 8000

1000 6000

500 4000

0 2000

-500 0

-1000 -2000

-1500 -4000

StockPL IndexPL CombPL StockPL IndexPL CombPL

 Summary of trading rules
• Decide on a pair to trade: AAPL v QQQ
• Calculate the Stress Indicator (SI) for that pair
• Buy the stock when SI < 10
• Exit the long stock position when SI > 50
• Calculate the 60-day moving average of QQQ
• If the trend of QQQ is down, hedge the stock
position with QQQ equal to the risk of the stock
using the 20-day ATR of each
• Exit the hedge when the stock position exits, or exit
the hedge when the trend of QQQ turns up
• Do not trade stocks under $3
• All trades are done on the next day’s open
 A fast way to build a portfolio
• The objective is to keep the portfolio filled with the most
volatile and (potentially) profitable markets

• Assume we scan 200+ pairs and want to choose the most likely
to succeed. Then, for each pair
o Calculate the return ratio over the past year (250 days)
o Calculate the recent 20-day return or the recent 20-day price volatility
o Identify whether this pair has an active trade
• Sort the information in order of the highest long-term ratio (at
least 2 years) and largest recent profits (60-90 days)
• Discard any market with a negative ratio
• Discard any market with no current position
• Start from the top and add markets until the portfolio is filled or
until you run out of stocks that qualify (in a bear market you
may not get any trades because there may not be short-term
profits)
• Using a strategy with a high chance of success, and
eliminating those markets that do nothing, will allow you to
beat the index even in an bull market.
 Maximizing your returns
• All performance records posted by professionals are
compounded
• In order to get those results you’ll need to track your
performance and chance the size of your position
when you get a new trade

• If you are up 10%, then the next trade should have

a size that is 10% bigger (size x (1 + 0.10))
• If you are enter a losing period, keep the same size
as your last trade. If you reduce size, the time to
recovery is much longer.
Sample portfolio returns (simulated)
 KaufmanSignals.com
• Provides three robust strategies, applied to
220+ stocks, 60 ETFs, and 60 futures:
o Timing (pairs logic) for stocks, sector rotation
o Divergence for 220 stocks, 60 ETFs, and 60 futures
o Trend for stocks, ETFs, and futures
• Provides a variety of dynamic and fixed portfolios of
different investment sizes for stocks, ETFs, and futures
• Provides all signals in all markets each day before the
markets open (8 am New York)
• Tracks performance
• Provides value-added analysis monthly
• Available by subscription, but there is lots to read if you
register for free
• Check out our new website www.KaufmanSignals.net
Any questions or comments?

Contact me at
perry@kaufmansignals.com

Copy of presentation and

TradeStation program
available on request