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PTMC team 29.10 2014

Basket trading in Protrader

Hey there, Protraders!

The number of traders who use the interconnection between different assets in their trading is increasingly growing with the development of global markets. And the more trading strategies use these interconnections, the stronger become the interconnections between financial instruments. Once in the dynamics of related assets the deviation from their "normal" state is observed, the traders who practice basket trading open positions in the direction that corresponds to the spread return (difference) between traded assets to the "normal" state. It is supposed that strength of assets’ interconnection compensates an anomalous instrument dynamics, herewith the trader will obtain profit. Large number of strategies which use the interconnection principle of several assets exists. Pair trading is the simplest example of such strategies which implicates trading by two interrelated assets.

Let’s give several examples of this strategy.

Let’s consider two currency pairs, EUR/USD and USD/CHF. It can be noted immediately that these two currency pairs will be strongly related to each other due to the fact that the Swiss franc in many ways is related to the Euro exchange rate, due to economic reasons. In this case, both currency pairs show the relation of these interconnected European currencies with regard to the US dollar. Correlation or dependency of these currency pairs is strongly negative; it means that if EUR/USD grows then USD/CHF falls and vice-versa. Look at the chart of the spread (difference) between the quotes of these two currency pairs. To provide this, use instrument “Portfolio” which is included to the functionality of the Protrader terminal. Go to Tools - > Portfolio.

use instrument “Portfolio” which is included to the functionality of the Protrader terminal.

Use button “+” to add a new portfolio which will include unidirectional trades (considering a strong negative correlation between currency pairs) by two selected assets in the ratio of 1 to 1.

Use button “+” to add a new portfolio which will include unidirectional trades

portfolio

Look at the spread chart of the selected instruments.

The spread chart of the selected instruments

As we can see, the spread of the selected currency pairs forms a certain price channel; we can also say that trend is not inherent to the obtained synthetic instrument. The strategies based on the reversion to the average, various channel strategies which anticipate the trading from the borders of the price channel to the average values will work well on such instrument. When using similar strategies we need to remember about such pitfalls, as the commission amount and the difference between Bid and Ask prices. The volatility of created synthetic instrument must exceed the value of costs on opening a position. Liquidity risks of the traded instruments also have a great meaning, since opening of the complex position by settlement prices is very important in such strategies, any slippage can lead to a significant reduction in profitability or to losses.

Let’s give one more example of pairs trading, the so-called calendar spreads. The calendar spread can be composed of futures on the same underlier but with different expiration dates. As an example we will consider the marketable calendar spread which consists of futures contracts on corn with delivery in December 2014 (ZCZ4) and in March 2015 (ZCH5).

The pairs trading, the so-called calendar spreads

As we can see, spread on the selected period is moving in a certain channel without a pronounced trend component. As in the previous example, the strategies based on the reversion to the average value of extremum will work well on such synthetic instrument. Of course, to create a synthetic instrument or basket of instruments with a strictly stationary channel movement character is almost impossible. There will always be a volatile breakthrough of the price channel which can bring a loss. Stop loss levels and phased entry into the position are used to limit price risks. With increasing the volatility and the breakthrough of the trade channel boundaries, each subsequent entry with the aim to reversion to the average values will have a higher profit and the probability of a positive outcome. During the trading of such synthetic instruments, the statistical advantage will be on the side of the strategies based on the reversion to the average (Mean Reversion).

Pair trading is only the simplest example of the basket trading. The strategy of equity basket trading against the index which includes those equities can be as an example of more complex basket. In this case the situations when one or several leading equities show dynamics different from the index are traded; or trading of the leading sector equities against one share that doesn’t correspond to the general trend of the sector. Based on the statistical methods, traders pick the basket of linked instruments so that it has the stable dynamics. The volatility indicators of the instruments are taken into account in this case, the basket restructuring in accordance with current market situation can be performed periodically. The methods of correlation and regression analysis, various econometric models are used for selection of the basket weight coefficients. In particular, the concept of cointegrated time series is often used. In econometrics a set of non-stationary time series for which there is a stationary linear remainder is called cointegrated. In other words, two non-stationary series (with time-varying probabilistic properties) at some their linear combination can give a stationary remainder in the result.

As was mentioned above, one of the problems of basket trading is the simultaneous position opening by all components of the basket. To solve this problem in the Protrader terminal we can useopening of the position from the “Portfolio” window. To provide this, choose New - > Order entry in the context menu.

To solve this problem in the Protrader terminal we can useopening of the position from the “Portfolio” window

But this method ofsimultaneous opening of the positions will be effective in that case if instruments included in the basket are traded on the exchanges that are available to the trading from one trading account. If the basket includes instruments traded on different markets, for example, several currency pairs and currency futures, then for simultaneous opening of the positions by basket components we need to use “Saved orders” function. To provide this, choose Terminal - > Saved orders in the menu.

for simultaneous opening of the positions by basket components we need to use “Saved orders” function

Next, use button “+” to add positions by all instruments included in the basket, taking into account the weight coefficients of each component.

use button “+” to add positions by all instruments included in the basket, taking into account the weight coefficients of each component.

use button “+” to add positions by all instruments included in the basket, taking into account the weight coefficients of each component

We can save the created portfolio by using “Save” button. Next, tracking the basket chart we wait for the appearance of the signal to open a position according to the trading system. If the signal was received, then using “Place active orders” button, we simultaneously open the positions by all basket components.

using “Place active orders” button, we simultaneously open the positions by all basket components.

Also “Saved orders” tool can be useful for quick opening of other multicomponent strategies with minimal delay. Thus, the operational risks when opening a position are minimized.

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