This segment focuses on pairs trades involving futures and explains ways to set up the trade using the notional ratio as well as the implied volatility adjusted ratio. The various slides are an excellent reference guide.
One strategy we sometimes utilize in our trading is pairs trading futures or stocks against each other (this segment focuses on just the futures). The sizing though, can be done two different ways. The two choices are the notional ratio and an implied volatility adjusted ratio.
The first step is to determine the correlations between the futures contracts. Should we want to create a pairs trade using the two products, we want the two underlyings to have a relationship.
A table was displayed showing the correlations between several well traded futures. They were /ES, /NQ, /YM, /ZN, /CL, /6E and /GC, the emini S&P 500, the Nasdaq 100, the Dow Jones, the 10-Year Note, Crude Oil, the Euro currency and Gold.
Once we analyze the correlations to determine if the products have a historical relationship,the next step is to look at the contract’s notional value, which is how many dollars one contract controls. We can calculate this by multiplying the current futures price by the dollar value per point of the contract. A table was displayed showing each product, symbol, dollar point, price and notional value.
We then have two choices. We can use either the notional value ratios or the IV adjusted notional value ratios. Dividing the raw notional values of two products results in a ratio we can use for the trade and we can use that to determine contract size.
Each contract has a different expected move and daily range. That means we can use implied volatility (IV) to determine the IV-adjusted notional ratio. This is our preferred method.
Another table displayed the futures products, symbol, implied volatility, IV adjusted notional value, IV adjusted ratio to the /ES and the tradable adjusted ratio to the /ES. It should be noted that these are sometimes very different figures than the ones provided by the CME.
Notes and Bonds have similar notional values so it’s reasonable to trade them 1 to 1. The problem is in factoring duration. Duration is a bond’s price sensitivity to a 0.01% movement in the interest rate. Sizing a bonds and notes futures pair using each contract’s duration gives us a ratio of 3 note futures to 1 bond future.
Watch this segment of "Market Measures" with Tom Sosnoff and Tony Battista to see how to size your future pairs and a great cheat sheet to improve your futures trading.
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