Dennis Leontyev has been trading stocks, commodities, currencies, index futures andoptions since he first came to America in 1990. Before founding Milangy Management Co.LLC, he previously served as the head trader of two different hedge funds based out ofLondon and Chicago. At his present location across from the Chicago Mercantile Exchange,he currently serves as President and Chief Investment Officer of Milangy, as well as thehighly-respected Options Strategist for the Hamzei Analytics’ Option Trading Service(“HOTS” --- http://www.hamzeianalytics.com/hots_details.asp.
Over many years, Mr. Leontyev has developed many valuable professional tradingmethodologies that few are able to access or replicate. Together with Jim Bittman of theCBOE and led by CBOE Options Institute Faculty Member and Hamzei Analytics Founder FariHamzei, Mr. Leontyev will participate in Chicago on January 17-18, 2006 in an OptionsInstitute Master Session (http://www.cboe.com/LearnCenter/MasterSessions.aspx). In thisnew offering from the Options Institute for serious traders and investors featuringhighly-experienced and well-respected educators, Mr. Leontyev will instruct participantson many of his unique trading methodologies. On December 14, 2005, Hamzei Analytics
Fari_Hamzei: We will be in Chicago next month with Dennis and JB teaching at theCBOE. We are very excited about that. Today you will get a flavor of what is in store forthose who will be joining us in Chicago in January. Now without further adieu here is JB,he will introduce the Star of the Show.
Jim_Bridges: My introduction will be very brief before turning it over toDennis. Dennis is the HOTS Strategist for Hamzei Analytics. HOTS is an option-basedtrading service on which you can obtain further information here --http://hamzeianalytics.com/hots_details.asp. Now we will let Dennis have the floor withoutfurther adieu.
Dennis_Leontyev: Hi everybody. Thank you for joining us today. I would alsolike to thank Fari and Jim for providing such a great service for traders. Today I wouldlike to explore one particular market-neutral strategy that has not been widelypublicized, but has endured for years as a successful approach used by many institutionalmoney managers and hedge fund experts. The strategy is called pairs trading. In simpleterms, pairs trading consists of buying one stock in an industry and selling short anotherstock (with which it has been paired via standards to be explained later), usually in thesame industry. This approach has become something of a lost (or rare) skill, but currentlyit is resurfacing in the mainstream. Pairs trading is a non-directional, relative valueinvestment strategy that seeks to identify two companies with similar characteristicswhose equity securities are currently trading at a price relationship that is out of theirhistorical trading range. This investment strategy entails buying the undervaluedsecurity, while short-selling the overvalued security, thereby maintaining marketneutrality. It can also be applied to futures and fixed income markets. The pairs systemis essentially an arbitrage system that allows the trader to capture profits from thedivergence of two correlated stocks. Pairs trading contains elements of both relativevalue and statistical arbitrage in that it often uses a statistical model as the initialscreen for creating a relative value trade. Technical analysis plays a very central rolein pairs trading. While it is certainly possible to create fundamentally-driven pairstrades, the methodology I like uses technicals to perform the majority of the analysisrequired before trading; fundamentals are used simply as an overlay to ensure that thereis no glaringly obvious reason to avoid a trade not captured in the technical indicatorsexamined. The following graphic example will illustrate the basic concept of pairstrading.
The first chart is Xilinx (XLNX); the second is Altera (ALTR).
These two stocks are highly correlated and belong to the same industry. These twocharts are almost identical. There are hundreds of pairs like this one in the US stockmarket. XLNX:
ALTR:
The third chart is the ratio of the two stocks (XLNX divided by ALTR). In other words,it represents what would happen if a trader were long XLNX and short ALTR over the lastfive years. XLNX/ALTR:
It is important that a pairs trade be done on a dollar-neutral basis (dollars investedin a long stock should be equaled to dollars invested in a short stock; not number ofshares). Notice an almost perfect oscillating pattern of the ratio. It basically meansthat, when this ratio is at a bottom of the range, a trader would go long XLNX and shortALTR; and when this ratio is at a top of the range, a trader would do the opposite. Thefourth chart is the same ratio with an RSI indicator added to it. I look for perfectoscillating patterns of ratios. As you probably know, momentum indicators are great forpicking tops and bottoms in a range-bound market and could be misleading in strong trends.XLNX/ALTR (w/ RSI):
A ratio of two highly correlated stocks has a high probability of being in a range;therefore a momentum indicator of your choice is a good predictor of entry and exitpoints. For example if you like a stock and want to buy it, but are afraid that the marketwill go down and will take this stock with it, you can create a pair long this stock andshort an ETF. In other words, you get rid of market risk. As an example, right now we arelong DIA and short IWM. I don't care where the market is going; my bet is that Dow stockswill be stronger than small cap stocks regardless of the absolute direction. To reducerisk and maximize profit potential, it is natural to apply options to an attractivestrategy such as pairs trading. The first and simplest approach is to substitute stockswith options. Instead of buying one stock and shorting the other, one could buy calls onthe long stock and buy puts on the short stock. Keep in mind that this strategy should betreated as one trade (not two different bets). A trader should open two sidessimultaneously and close two sides simultaneously. In the majority of cases, one side willbe a winner and one a loser. The idea of a market neutral strategy is for winners tooutperform losers. In this case, a trader essentially strangles a pair of stocks. It isrecommended to use in-the-money or at-the-money options to avoid fighting theta decay. Ifthe pair performs as expected (long stock outperforms short stock regardless of theabsolute direction), it is a winning trade. I would certainly like to see my longs go upand shorts go down. But it rarely happens, because we work with correlated stocks.
So your thinking needs to be adjusted to being a neutral trader. Also, if there is asignificant move up or down for both stocks (remember that these are correlated stocksexpected to move in the same direction), it is also a winning trade, regardless of whichstock outperforms. Just as in a straddle or strangle strategy, if there is a large enoughmove in one direction, one side can appreciate indefinitely, while the other can onlydecline to zero. As you can see, by substituting stocks with options, a trader cansignificantly improve the probability of a successful trade. That is another advantage ofusing options. If you don't sell them naked, there is a limited risk and in caseofneutrality, higher probability. Another interesting approach to applying options topairs trading is to compare implied volatilities of the two stocks in a pair. If therewere a divergence in implied volatilities of the two analyzed securities, it would presentanother arbitrage opportunity. In this case, you have a double arbitrage going at the sametime: 1. prices of correlated stocks and 2. implied volatilities of correlated stocks.Trading as you know is game of probabilities. Don't be a gambler, be a casino. Let'sassume that options on ABC are more expensive than XYZ. Instead of buying ABC and sellingshort XYZ, a trader might consider selling expensive options and buying relatively cheapoptions while still preserving a pairs trading approach. One would sell ABC puts (neutral/ bullish bet on ABC) and buy puts on XYZ (bearish bet on XYZ).
If stocks go up, options expire worthless, and a trader captures the difference inputs. The same outcome holds true if both stocks remain at the same price by expiration.If both stocks go down and ABC outperforms XYZ as expected (XYZ declines more than ABC),there is potentially unlimited gain possibility. This strategy can lose money only if atrader’s pairs trading analysis is wrong. Try not to use naked options. There arehundreds of options strategies (spreads), which will allow you to do a pairs trade withthe options greeks on your side. These strategies are used by only a handful of hedge fundmanagers and are not available to the majority of traders and investors. Mastering thisapproach will open unlimited new possibilities and might change the way you approach thefinancial markets. These strategies are not designed to hit a home run. They are stable;you can sleep well at night and stop being concerned with where the market is going. Forexample, if I like Intel (INTC), but I am afraid that the market is about to go down. ThenI would be long INTC and short Semi-conductor Holders (SMH). Better yet, I would sell aput spread on INTC (bullish protected bet) and buy puts on SMH (bearish bet) because theimplied volatility is higher on INTC. I am ready for questions.
James_Kennedy: Where can we get more info on pairs trading?
Dennis_Leontyev: James, very few people use this strategy. Most of them are closelyheld secrets by hedge fund managers. You can find info on pairs trading, but very littleon options in pairs trading.
James_Kennedy: Thank you.
Fari_Hamzei: http://www.cboe.com/LearnCenter/MasterSession.pdf
Jim_Bridges: As we open it up for questions, the link Fari posted above is inresponse to James Kennedy's question. Secondly, it's clear that these strategies aretested and are performing extremely well as HOTS performance clearly indicates ---
Dennis_Leontyev: I prefer pairs to be beta neutral.
Bijan_Khezri: Could you expound on your answer please?
Dennis_Leontyev: For example, it does not make sense to compare the impliedvolatility of Google (GOOG) to the implied volatility of International Paper (IP). So Icompare implied volatilities to their 52 week average.
Cindy_Faber: How do you balance dollar neutral (mentioned earlier) andbeta neutral, since the two are often at least a little different?
Dennis_Leontyev: You can easily adjust number of shares or option contracts to bebeta neutral. To be truly neutral, one has to pay attention to beta, not just dollarexposure.
Bijan_Khezri: Am I to understand that you take the 52-week average of thestock and the 52 week average of the sector fund, and the ratio is what you use to addcontracts to the less volatile security?
Dennis_Leontyev: Dollar Neutral trade being long QQQQ and short SPY has a bullishbias most of the time because QQQQ is more volatile. You need to adjust for that in orderto have a pure neutral NASDAQ/SPX trade.
Bijan_Khezri: How exactly?
Dennis_Leontyev: Here is an example. ABC is at 50 with a beta of 1 and XYZ is at100 with beta of 1. So you buy 2 ABC and short 1 XYZ. If ABC's beta is 2 then you buy 4shares of ABC. Now you can calculate number of options contracts to be beta neutral.
Bijan_Khezri: Thank you. That is clear, but where did the 52 week thingcome in?
Dennis_Leontyev: Implied Volatility of options.
Bijan_Khezri: Ah! Muchas Gracias.
Dennis_Leontyev: For instance, an implied volatility of 35 could be high for SPY,but low for EBAY. That is why I work with averages. I hope I was able to answer thisquestion.
Bijan_Khezri: When you say averages, you mean the average of beta for thestock over a 52 week period, or the average of something else.
Dennis_Leontyev: The average of implied volatility over a sufficient period like 52weeks or longer.
Bijan_Khezri: Where does one get the beta data for that length of time?
Dennis_Leontyev: Any trading software or financial web site will give you currentbeta.
Bijan_Khezri: What about the historical beta?
Dennis_Leontyev: All you need is current beta.
Fari_Hamzei: Hamzei Analytics offers an Active Beta Matrix.
Bijan_Khezri: I thought you just said you needed an average beta of 52weeks or longer?
Dennis_Leontyev: No, you need the average implied volatility of the options, notbeta.
Bijan_Khezri: In that case where does one get historical impliedvolatility?
Fari_Hamzei: We also have historical implied volatility on Hamzei Analytics at theSuperPlatinum level.
Dennis_Leontyev: Thanks Fari.
Fari_Hamzei: No no, THANK YOU!
Jim_Bridges: Does anyone else have a question?
Bijan_Khezri: Well, I am glad that Fari has such knowledgeable friends. Ihave another question, but I will cede the floor to others and come back later. ThanksDennis.
James_Kennedy: Thanks again Dennis.
Dennis_Leontyev: Thank you guys.
Mollie_Mossman: When do you calendarize your trades?
Dennis_Leontyev: You mean options?
Mollie_Mossman: Yes.
Mollie_Mossman: In other words, instead of doing a vertical, doing acalendar vertical, for example.
Dennis_Leontyev: Depending on your time frame. I usually use 3 to 5 months if I buypremium and 1 month if I sell premium.
Fari_Hamzei: What leads you to your preliminary filters before finalizing thepair trades for HOTS each Sunday? This was asked by a large hedge fund manager that getsyour report, and I promised him that I would ask you.
Dennis_Leontyev: I have a pairs trading software, which I developed with somesoftware engineers a few years ago. I use it for my hedge fund.
Fari_Hamzei: So don't give the house away, but give us some clues please!
Dennis_Leontyev: Besides the software, I have my "favorite" pairs; abouta hundred or so that I have traded on a regular basis for many years. I also do a simpleanalysis like: “I like this stock (technical reasons) and I want to short anotherstock. If they are in the same industry, this could be a pairs trade.”
Fari_Hamzei: So, how does the software go about gathering preliminary matchingpairs, let’s say absent of your favorite’s list?
Dennis_Leontyev: I can say for example: show me semiconductor industry stockscorrelated 75% or higher on a 2 year basis, 6 months basis, 1 month basis with their ratio(one stock divided by the other) oversold (say RSI at 18) and so on and on and on. Plusthere are proprietary indicators in this software.
James_Kennedy: For the HOTS auto-trade do you use limit orders or market orders forentry and exit.
Dennis_Leontyev: Pairs trades have to be market. Limit order might buy you onestock and never short the other. That is bad.
James_Kennedy: Thank you.
Fari_Hamzei: Are there any other questions? These will have to be the last ones, asit is getting late and I have been here since 0400 PST.
Dennis_Leontyev: Fari, you need to sleep sometimes.
Fari_Hamzei: I can sleep after the Wiley Book, but not now.
Dennis_Leontyev: Got it.
Fari_Hamzei: Thank you all, and THANK YOU DENNIS. You have done an outstanding jobthis year sire, and we are darn proud of you.
Dennis_Leontyev: Thank you everybody. You can contact Fari or me directly with morequestions.
Fari_Hamzei: Of course, you may send your questions to Dennis@HamzeiAnalytics.com.
Jim_Bridges: Thank you Dennis, great stuff. See you tomorrow and in January at theCBOE.
Gregory_Brack: Thanks Fari and Dennis, you guys are great! I reallyappreciate the invitation to this chat.
Stephen_Okeefe: Thank you very much!
Dennis_Leontyev: See you guys.
Fari_Hamzei: Our next chat will be with the Director of Program Development at theCBOE, Jim Bittman. This chat will take place on Jan 10, 2006. The transcript oftoday’s chat will be posted in a few business days and emailed to all of ourSuperPlatinum subscribers. Please feel free to share the transcript with your tradingbuddies. Happy Holidays to all. Also do not forget the less fortunate ones -- please helpthe underprivileged this holiday season. Thank you and good night.
Jim_Bridges: Please feel free to access the rest of the site tonight. It will beback tomorrow for the regular trading session. Have a great evening everybody.
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