In our previous post on assets management, we examined the volatility-based approach for building long-short pairs of stock, factoring in the VAR confidence level. Now, let us presume that we have identified some quantity of stock we would like to use for opening long positions based on this stock’s location within the lower range of its VAR tail quantiles, as well as use some stock for opening short positions based on its location within the upper range of its VAR tail quantiles.
How should we determine what particular stock to bring into long-short pairs and what stock quantity should be used? The first thing we should agree upon is that we will apply the market-neutral strategy here. How do we define “the market” pertaining to these securities? In this case, “the market” implies some benchmark that is common for both securities in one pair, - a so-called senior index. This senior index can be S&P, can be Nasdaq, or any other index that covers any of these potentially paired together securities.
Reciprocity with the senior index
Having determined the senior index, we can calculate the risk exposure and our stock’s covariance with this index. Risk exposure may be denoted by the market capitalization, and correlation is designated by the correlation factor. Thus, determining the reciprocal influence of stock on the senior index, and the influence of the senior index on the stock is the first step on the way to identifying several securities with similar metrics as risk exposure, senior index, and covariation with the senior index. We will allocate our long-short pairs of stock based on these two groups of matching securities.
Measuring the stock against liquidity and volatility
To limit the quantity of the matching securities to the two to be combined in a long-short pair, we will compare them by their liquidity and volatility, singling out not only particular securities to be paired but also a concrete value of the stock in the long and short positions.
By way of example, let us assume one equity alternates on average by 2% per day, and the other does by 4% a day. Having said this, due to its liquidity, the first equity may pass through the whole trajectory over a day, whereas the second security trend may bounce back and forth between the lower and the upper range of its volatility boundaries. We must take into consideration the fact that combining our securities under a common variable of correlation of the security liquidity or volatility, we can single out the two securities with the most matching liquidity or volatility indicators from the groups of already selected securities classifies according to their risk exposure, market capitalization and covariance with the senior index. The small difference in these indicators’ values will be offset with the difference in the volume of positions held by these securities corresponding to their long-short sides.
Minor is also of the essence
Another additional statistical measure to be determined for every security in a prospective long-short pair is the minor index, or the security industry index. Assessment of a particular stock's over-performance or under-performance against the minor index will also affect our decision concerning the selection of one or another stock to be placed on the long or short side of our pair.
Having correlated all these parameters together, we will figure out a general model for determining securities to be tied into our long-short pairs. Now, that we move to form these pairs, we must apply benchmark ratings that will enable us to select the most suitable pairs of stock out of the multitude of pairs: the ones that are worthy of keeping in our portfolio of stock providing the market-neutral result.
How we can combine these pairs in an optimal market-neutral portfolio, considering the exposure to risk, the money position, the future market correlation, and other things will be covered in our next article. Stay tuned with us, and you will learn all these things and many more in our next post.