Finding the Perfect Pair
At a time when hedge funds are constantly seeking new trading ideas, Louis Capital Markets (LCM) has carved a niche in quantitative equity trading that is catching the attention of the smart money. In January, LCM -- an independent global agency broker headquartered in New York and London -- launched the latest version of its statistical long/short equity model (SLSM) for trading U.S. and European equity pairs. The quantitative model automatically signals when pairs of stocks in the same industry, such as eBay and Google, are moving away from their historical averages and predicts when they will revert to the mean.
"The pairs are stocks that are within one sector -- banks, telecoms, insurance or retail," explains Olivier Clementin, a proprietary trader at BNP Paribas in Paris who has used the LCM model as it has evolved over the past five years. "I use the model mostly for European equities, but I get five pairs on Europe and five on the U.S.," he says.
"The beauty of pairs trading is that a down movement is offset by an up movement," explains Adam Sussman, senior analyst and consultant at TABB Group. "If they always trade X percent away from each other, and all of a sudden eBay drops or Google goes up, if the move is outside that perimeter, [traders] look for a certain percentage [move]," he says.
LCM's strategy is based on mean-reversion long/short trading, a theory suggesting that prices and returns eventually move back toward the mean or average. Traders wait for two days of mean reversion before entering the trade. "It's useful to have signals when stocks move away from the way they have been trading," says BNP Paribas' Clementin. "It means if in the past they had been trading around a certain ratio, and if the ratio moves away from where it had been trading in the past, we expect the ratio to come back."
Model Building
With the explosion in the number of hedge funds, there is more interest in quantitative strategies, says Michael Benhamou, cofounder and managing partner at Louis Capital Markets in New York. The 75-person firm, which provides execution services and equity derivatives in the U.S. and Europe, is split between New York and London. When the firm was founded in 2000 -- the same year that the bull market crashed -- hedge funds requested that it develop a market-neutral strategy. LCM set up a quantitative research team internally that worked on the model. Clients provided feedback on a beta version, and LCM kept analyzing past trades to correct failures and make the system more efficient. In an exclusive interview with Wall Street & Technology, LCM provided some insights into how the proprietary model works.
Initially, the model scanned every equity available in the U.S. market from the Nasdaq small cap stocks to the larger Dow Jones index components, according to Benhamou. "As we grew, we realized we had to be in more liquid names," he says. Today, the model tracks a total of 600 stocks in the Standard & Poors 500 Index and the Nasdaq 100 Index, generating about 180,000 pairs (each stock can be traded against every other stock in its industry sector).
LCM applies a similar model to big European stocks listed in the Dow Jones EuroStoxx index. In addition, LCM has an ETF Tracker that scans the biggest exchange-traded funds. For example, SWH is a software ETF that includes SAP, Microsoft, Adobe and Oracle, while XLF tracks financial stocks, including Citigroup, Bank of America and AIG.
"It's market-neutral in terms of a sector," says Julien Gaubert, who is in charge of software programming at LCM. "If you trade a stock against the same ETF of the sector, if the stock is down, then you're hedged against a move in the sector."
The Quest for Alpha
Each morning LCM, which provides execution services to 500 customers worldwide, distributes a list of the top 15 pairs in U.S. equities and the top 15 pairs in European equities to about 250 customers who work at hedge funds, proprietary trading firms and long-only funds. The model works on a Bloomberg terminal. E-mails are sent through the Bloomberg Mail system as well as via regular e-mail. "The client is provided with the top 15 pairs," says Gaubert. Traders can click on a link to LCM's secure Web site where they can see detailed descriptions of five pairs in a spreadsheet. They must speak to someone by phone at LCM to receive more information on the remaining pairs.
According to a recent report by TABB Group, hedge funds are under pressure to increase alpha, which it defines as returns attributed to the hedge fund manager instead of exposure to various sectors. "It's becoming more difficult to deploy ever-increasing amounts of capital. They're looking for ideas everywhere," says Sussman. "I'm sure a hedge fund is not going to take every idea from LCM or elsewhere. One idea that nets them some alpha is going to be returned in kind."
But the quest for alpha not withstanding, the major reason that brokers present short-term trading ideas to their customers is to generate commissions. "This is all about the exchange of an investing idea for commission," asserts Sussman. In addition to its SLSM, in June LCM planned to offer its own direct-market-access solution to make it easier for customers to execute anonymously (see related sidebar below).
Pairs trades usually are meant for investors looking for a short-term profit in the market. "The average time for a trade to be open is 15 days," says LCM's Gaubert. A position could be held as long as a month.
But hedge funds and proprietary traders have their own models and market data feeds as well, so they are not necessarily relying on LCM's model exclusively. "It's just an additional way of generating ideas," says BNP Paribas' Clementin. "Sometimes, an idea can be generated based on the news flow, on the earnings, so this is an additional source of ideas," he says, adding, "I try to understand the story. I'm not choosing it as a black-box tool to enter trades just based on the score -- I look at what's happening."
Numbers Crunching
There are three phases to the LCM system. First, there is an elimination phase to filter out the irrelevant pairs. To reduce the universe of 180,000 pairs down to about 200 to 300 remaining pairs, LCM applies a number of criteria. For example, pairs must be in the same industry and stocks must be liquid with at least $20 million in U.S. trading volume. Further, LCM defines the different correlation averages for each industry sector.
"Correlation is really the key data in the model -- the data that drives the long/short opportunity," says LCM's Gaubert. For instance, the oil and gas industry has an 85 percent correlation at minimum, while Internet stocks have a 40 percent correlation.
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio
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