Markets "breathe", or move as a collective whole. Some issues run stronger at times than others, and some run weaker than others at given times. The strength of the extension, or one way uncompensated movement, within an issue as compared to another issue really does not have any direct correlation. It does have "potential" to correct an imbalance there, but those imbalances go uncorrected more often than not. The imbalance I am interested to exploit is the direct ratio of one issues extension high/low to reset compared to anothers extension high/low to reset. Since all extensions reset/compensate eventually, an issue that has more travel to reset will run relatively strong/weaker (depending on extension direction) than an issue with a smaller area to cover to reset.
The paired arbitrage trade is initiated as a delta neutral trade. This means, the delta is 0.00, you are long one issue while simultaneously shorting (long puts) the second issue. If the pair, let's use QQQQ and SPY for example, move together, up say 5%, the trade does not lose or gain anything. If they both drop 5%, again the trade does not gain, nor lose. If the two issues seperate further, the trade will experience draw-down, this is typically a great opportunity to add to the trade, for they will correct the imbalance (due to the fact every extension will reset eventually). The trade is exited when either of the two issues actually compensate their extension, or when the gap that existed is closed. The pair typically will be directly correlated to each other, hence not an issue paired with it's inverse. Since the pair will generally drift in tandom, defining hard addition targets and exit targets, in advance, is extremely difficult. The trade will be controlled more by the gain/draw-down percentage to the overall utilized capital. For instance, if the trade is executed in a 3:1 ratio (QQQQ:SPY) with 10K of trading capital, the addition level may be when you have a 5% draw-down. Hence, when the 10K trade has a net liquidity of 9.5K, you will add XX lots to take further advantage of the pricing discrepency. When the trade is added to, you want to re-balance delta. If both issues rose in absolute price value, the long position (if options, of course) will gain delta, the short position (long puts) will lose delta. If you add 1 lot (recall 3:1 ratio above) you may have to add one additional contract to the short position to assist in balancing delta.
The paired arbitrage trade is typically of very short nature and played on the major ETFs, for they run in tighter correlation. WHen these opportunities come up, the following information will be listed in the newsletter, and updates to the trade will be via email/text.
Entry time (not price, due to the trade pair)
expected percentage to close the gap (ie, the percentage which seperates the two issue from being "in balance")
percent draw-down of addition
Exits and any specific delta balancing will be addressed via text/email
