Reader Comment on Poor Man’s ETF Arbitrage

Reader Comment on Poor Man’s ETF Arbitrage:

Nice piece. Few questions, if you don’t mind (acknowledging I have not used TradeStation in quite a few years, which may be the root of my misunderstanding): (a) can you clarify your intent with step 2: why you are building a custom index (since standard ETF basket arb assumes the hedge ratios are estimated via cointegrating regression)? (b) what is the “log ratio”, in this context? (c) what data source you use for intraday? Thanks in advance.

First off, thanks brother. I actually thought this was one of the nicer posts since ETF arb is such a common and still somewhat profitable strategy. Also it has been very difficult to do without MatLab or some higher end back-testing platform. Second let me say that I’ve been slacking since starting my new position, trying to make a good impression at my new gig. I am around a lot of very talented traders and although I can’t say I’m learning anything ‘new’ per say, I am hopefully in a very good position going forward. Only time will tell. Now on to your questions:

(a) By custom index I meant a custom list of securities that represent an ETF or Index. Practically you wouldn’t trade all 100 stocks that comprise the Q’s, perhaps just the top 10 or top 5. The exact number is up to you but should represent the index/ETF fairly closely. The less components the more opportunities but the lower the tracking so there’s a trade-off to measure. One can use regression weighting or standard index weighting, my opinion is it shouldn’t matter a great deal either way.

(b) I can’t remember where I actually used log ratio but I use it fairly often when comparing two securities. It allows one to ‘normalize’ for stock price, a similar absolute value move in a $20 is very different from the same move in a $200 stock. Also if you look at percentage change for securities, they are considered much more normally distributed-however fat tails do exist in those as well.

(c) I’m using TradeStation data, it has its problems but readily available to me and I believe the error in 5 minute charts shouldn’t be too bad. A reliable data source is very important when analyzing intraday strategies but what’s a poor man to do (hence Poor Man’s ETF arbitrage). In reality, even with the best data you are subject to the whim of the market; there’s no sure-fire way to know how accurate your fills will be compared to a back test and since the method to check (i.e. Go LIVE!) is the same, why not save yourself some time. Hopefully start-up capital is not an issue, lol!

Hope this helps and looking forward to getting back into blogging with some interesting stories and analysis.

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~ by largecaptrader on January 5, 2010.

3 Responses to “Reader Comment on Poor Man’s ETF Arbitrage”

  1. Thanks for clarification, makes sense; log ratio of two prices (as opposed to log price differences, per continuous-time finance) is interesting, and one I will explore. Good luck with your new gig, and look forward to new posts as your time permits.

  2. Although fills are pretty hard to backtest, do you know of any good links about calculating fills/slippage costs?
    Sorry if it’s mentioned, but I didn’t find a way to search your blog, is there a search field (I don’t see it using Firefox on Windows). Cheers, Cord

  3. I don’t know any specific links or articles off hand. I’m sure I’ve come across them. I usually check for ‘trade through’, i.e. if I am looking to short at limit, price must trade at least .01 above my limit, or .01 below on a long to trigger a trade.

    This invariably destroys most high frequency equity curves. For those that still maintain positive curves, I make the assumption my actual P&L will be somewhere between. If I’m happy with that then I’ll trade it small and compare fills with current testing and calculate a variance to get an even clearer idea.

    If you have access to data and are paid a couple hundred K to analyze high frequency data, there are a number of tests to analyze DOM, time to trades, etc. but I think it’s overkill for small capital.

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