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The European Debt Crisis - Part II

What we are all watching unfold right now is a complete and total financial nightmare for Italy. Italy is the eighth-largest economy in the world and the fourth largest in Europe. Its debt totals more than $US2.5 Trillion… 

To put it in perspective, if you combine the value of Greece’s, Portugal’s, Ireland’s and Spain’s debts, the combined value is less than Italy’s debt all together!

Italy has long been regarded as “too big to fail”, but also, “too big to bail out”…. Its gross domestic product was over $US2 trillion ($1.97 trillion) in 2010. Greece, Europe's other basket case, has a GDP of $US305 billion….

Red Alert

Italian bond yields are soaring to incredibly dangerous levels, and now the yield curve for Italian bonds is turning upside down. So what does that mean?Normally, government debt securities that have a longer maturity, pay a higher interest rate. 

There is typically more risk when you hold a bond for an extended period of time, so investors normally demand a higher return for holding debt over longer time periods. But when investors feel as though a major economic downturn or a substantial financial crisis is coming, the yield on short-term bonds will often rise above the yield for long-term bonds. 

Chart – Italian Bond Yields

This happened to Greece, to Ireland and to Portugal and all three of them ended up needing bailouts. Now it is happening to Italy and Spain may follow shortly, but the EU cannot afford to bail out either of them. An inverted yield curve is a major red flag. Unfortunately, there does not seem to be much hope that there is going to be a solution to this European debt crisis any time soon.

We are witnessing a crisis of confidence in the European financial system. All over Europe bond yields went soaring today. When I finished my article about the financial crisis in Italy on Tuesday night, the yield on 10 year Italian bonds was at 6.7 percent. I awoke today to learn that it had risen to 7.2 percent.

Part of the reason why Italian bond yields rose so much on Wednesday was that London clearing house LCH Clearnet raised margin requirements on Italian government bonds.

In my view, 7% is a 'tipping point' for any large debt-laden country and is the level at which Greece, Portugal and Ireland were forced to accept assistance

Solutions?

German Chancellor Angela Merkel is saying that fundamental changes are needed.... “It is time for a breakthrough to a new Europe”.

So what kind of a "breakthrough" is she talking about? Well, Merkel says that the ultimate solution to this crisis is going to require even tighter integration for Europe....

That will mean more Europe, not less Europe.

What does this mean? And more importantly, will this solve the underlying problem?At the end of the day, governments are to blame and these governments need to be made accountable... to put it simply, governments need to reduce their reliance on debt - cut spending, increase taxes, reduce their need to borrow funds, cut deficits by selling assets (roads, infrastructure, utilities) and save more.....

Yes, central banks around the world need to help and restore investor confidence (even though, it’s not their underlying role...); but it is governments and the politicians that are running these governments, that are to blame.

Money Management

Before committing your hard earned money to live Pair Trading there are a number of money management decisions you need to make:

1. What is the minimum capital requirement?

Trading should be treated like a business, and most business fail to succeed in their first year mostly due to a lack of capitalisation – trading is no different. You need realistic expectations about how much capital is required and how the ebbs and flows of trading will impact your account balance. Using leveraged instruments like CFDs for example with a capital investment of $10,000 should be the minimum required.

2. How much leverage and drawdown can you tolerate?

Professional trading system developers use the data generated from back testing to help ascertain appropriate position sizing levels for trading their system. However, a trading system is made up of several pairs and the combined trade performance between them. The running profit and loss of your trading system is also determined by the amount of leverage, slippage, and transaction cost applied.

Using a software application like Market System Analyzer you can simulate different money management strategies to determine critical performance statistics like: Maximum system draw down, maximum number of consecutive losses, average return on investment by week and many more. Armed with this information you should have a very good idea about how much leverage to apply to your Pair Trading system, and what maximum draw down (loss) to expect.

Implementing proper money management to your Pair Trading is critical to your success, and for people who don’t have the time or discipline to research the optimum position sizing for their Pair Trading system then fill out your details to the right and a licensed professional will contact you.

Importance of trade execution

The execution of a Pair Trade is critical in determining its profitability. Given that the trader is only looking for convergence of between 3-4% for each trade, “slippage” is a critical factor in the success of the trade. For example, assuming that your software generates a buy signal on SLB at $20.05 and a corresponding sell signal on CAB at $19.55, both legs must be filled in order for the Pair Trade to work and cannot be left exposed.

Provided that the trader enters SLB at $20.50 and CAB at $19.30, the “slippage” on execution would reduce the profitability of the trade. The trader should only take the trade if the “slippage” is less than 0.25% and hence, must be minimised. Accordingly, real-time analysis, execution and live data are critical inputs in the success of a Pair Trade. 

Liquidity also plays an important role in the execution of a trade. If there is not enough liquidity (i.e. the market is thin and there aren’t enough buyers and sellers on both sides in the corresponding market depth of the security), the slippage would be magnified and hence, the Pair Trade would not work. For that reason, it is important that the trader considers the liquidity of the stock and ensures that market depth is strong.

Investor Access to Pairs Trading

Pairs Trading as an investment strategy sounds like a good way to invest in an uncertain market.

But the analysis seems complicated and too hard to do. Who wants to spend hours researching which pair of stocks to go long or short? Who is confident that they've got the right pair? When do we enter and exit each pair?

That's a lot questions. You'll need to stay at home and wait for signals from our proprietary system and understand how 'slippage' affects the divergence from standard deviation and your profitability - if you cannot manage all these then what?

Trading yourself is tiring and for time poor individuals, it just doesn't work. Is this a possible reason why retail investors haven't been exposed to this type of strategy? Maybe. 

Add your contact details to the right and we'll give you a call on how you can maximize Pairs Trading results with automated professional trading - done on your behalf.

"Pairs trading – Potentially twice the return, half the risk" Fairfax Media

While I was searching the net for any commentary on Pairs Trading, I came across this article in the Business Day section of Fairfax Media...

Read the business day article

Here are some of the key points:

"The logic of pairs trading is to make money on the price difference or spread between any instruments"

"The strategy known as pairs trading has the potential to increase returns without being dependent on the direct of the market"

 "Dividends and interest paid and received throughout the trade but don't really amount to much. On one side of the ledger you pay interest and are entitled to dividends. On the other you receive interest on your short sale but pay dividends. If trading through a CFD provider, this is all handled seamlessly"

This article gives a quick run down of what Pairs Trading is all about, however if investors need to do research, analysis and enter/exit positions and risk manage their account. Who has the time to do all this?

Volatility of Equity Markets

August 2011 was one of the most volatile months on record, in which the US stock market fell from 12,292 on 1 August to 10,444 on 9 August – a retreat of over 15.0% in five trading days.

DOW JONES

Volatility in August (measured by the VIX index) also surged from 25.00% to 40.00%, following contagion fears in Europe, US credit rating downgrade and a slowing Chinese economy.

Traders, global fund managers and institutions watched in horror as their positions were liquidated and stop losses were triggered. The volatility of equity markets hemorrhaged  wealth from investors who were willing to hold. Gains made in shares can be quickly eroded and "getting back" those gains could take longer than you desire.

Why Trade Pairs?

The strategy known as pairs trading has the potential to increase returns without being dependent on the direction of the market.

With this strategy there are scarce opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity. While it is commonly agreed that individual stock prices are difficult to forecast, there is evidence suggesting that it may be possible to forecast the price—the spread series—of certain stock portfolios.

The main advantages of pair trading are as follows:

(i) The Pair Trade helps to reduce sector- and market-risk. For example, if the whole market crashes, and the two securities fall along with it, the trade should result in a gain on the short position and a negating loss on the long position, leaving the profit close to zero in spite of the large move.

(ii) Pair Trading is a mean-reverting, non-directional strategy, betting that the prices will eventually revert to their historical trends. Back test results show that this is the case among specified sectors.

(iii) Pair Trading is a substantially self-funding strategy, since the short sale proceeds may be used to offset the long position.

(iv) Pair Trading provides investors the ability to trade across various asset classes and global markets (not only restricted to stocks). The ability to go long and short in different securities reduces cross country risk and enhances the diversification of a portfolio.

What is Pairs Trading?

Most stock market investors buy shares and want the market to rise. A smaller group of investors take short positions and want the market to fall. Pair traders don’t mind what the market does - simply seeking to profit from the relative performance of two related stocks. Used by institutions, hedge funds and investment banks for over three decades, it remains surprisingly under-utilized by the average investor.

The pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. The pair trading was first pioneered by Gerry Bamberger and later led by Nunzio Tartaglia’s quantitative group at Morgan Stanley in the 1980s.

When the correlation between the two stocks temporarily weaken (i.e. one stock moves up while the other moves down), the pair trade would be to short the outperforming stock and to take a long position on the under performing stock, betting that the "spread" between the two would eventually converge (or come together).

The divergence within a pair can be caused by macroeconomic factors such as changes in interest rates, government spending, unemployment rate or micro-economic factors such as changes in supply/demand forecasts, production reports, revenue margins and management changes.