Table of Contents

Table of Contents

1

What to expect?

1

2

Pair Trading logic

6

3

Pair Trading, Method 1, Chapter 1 (PTM1, C1) -Tracking

Pairs

13

4

PTM1, C2 ¨C Pair stats

21

5

PTM1, C3 ¨C Pre trade setup

30

6

PTM1, C4 ¨C The Density Curve

39

7

PTM1, C5 ¨C The Pair Trade

48

8

Pair trade Method 2, Chapter 1 (PTM2, C1) ¨C Straight line

Equation

59

9

PTM2, C2 ¨C Linear Regression

66

10

PTM2, C3 ¨C The Error Ratio

77

11

PTM2, C4 ¨C The ADF test

86

12

Trade Identification

98

13

Live Example ¨C 1

104

14

Live Example ¨C 2

117

15

Calendar Spreads

121

16

Momentum Portfolios

130

CHAPTER 1

What to expect?

1.1 ¨C What is a trading system?

Such a glorious day to start this module! Here is the headline that rocked the stock

markets today ¨C

Yesterday i.e. 24th Oct 2017, the Finance Minister announced that the Government would

infuse Rs. 210,000 Crore into the Public Sector banking system, which is basically an effort

to save the PSU banks from the deteriorating NPAs (Non-performing assets).

How did PSU Banks react to this announcement? After all, this is a lease of life to the PSUs.

Well, they were jubilant, as expected ¨C

As you can see, the PSU Bank index shot up 27.75% at opening.

Some of the PUS stock options were on steroids, here is the hero of the day ¨C

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Punjab National Bank¡¯s 160 Call option expiring on 26 th Oct 2017, shot up 20,600%

overnight! If you had bought 1Lac worth of option on 24th Oct, it would have translated to

2.02 Cr on 25th Oct morning. So clearly, there is a lot of action in the market today.

Earlier in the day, my colleague and I were looking at the way markets were behaving and

trying spot an opportunity, and here is something that looked interesting ¨C

Bank Nifty Index too joined the party, with the index going up nearly 3% (look at the image

of the sectoral indices above). However, a 3% move on Bank Nifty was quite questionable

considering the fact that PSU banks contribute just around 10% to the Bank Nifty index,

look at the index constituents and its weights below ¨C

Considering this, my colleague and I decided to write a short strangle on Bank Nifty and

collect a premium of close 253 points per lot, obviously hoping that the volatility would

die and premiums would reduce.

I don¡¯t want to debate about the reasoning of this trade ¨C whether it¡¯s going to make

money or not is not really the concern, although I hope it does

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However, I want you to think about the thought process behind this trade. The trade idea

originated through what I consider as ¡®systematic deduction¡¯. To make such systematic

deduction and find opportunities, you need to question what is happening in the market

and sometimes be willing to take contrarian positions, which is exactly what we did.

¡®Systematic deduction¡¯ is one of the most popular methods market participants adapt to

trade the market. However, not all systematic deductions are right, you could, of course,

succumb to biases and make systematic errors while making these deductions.

Nevertheless, systematic deduction is one of the other popular techniques to trade. Other

popular trading techniques being ¨C

o

Trade because your gut says so

o

Trade because my friend says so

o

Trade because the guy on TV says so

o

Trade because my broker says so

None of the above mentioned ¡®approach¡¯ to trade the market, including the ¡®systematic

deduction¡¯ can really be defined as a process. These are ad-hoc methods, which cannot

really be quantified or backtested.

Any approach to trade where you cannot really define ¡®the approach¡¯ as a process is not

considered as a trading system.

On the contrary, if you can define the approach and can quantify the process to trade the

market, then you are essentially talking about a ¡®Trading System¡¯, which is exactly the

focus of this module.

1.2 ¨C Trading system ¨C the Holy Grail?

The moment you talk about a trading system, people generally tend to think of these

systems as a sure shot technique to make money, or in other words, they approach these

systems as a money-making machine. They expect profits to roll from the first trade itself.

Unfortunately, it does not really work that way.

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