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We will go over a recommendation by using one example. We sent a recommendation on 19th Feb 2013 of buying NMDC and selling HINDALCO.
Here is the recommendation:
Sell NMDC - Buy HINDALCO
Entry Threshold: 1.5
Target Divergence: 0
Stop Loss Divergence: -2.5
Current Divergence is: -1.45785
NMDC is trading at 137.25.
HINDALCO is trading at 98.85.
Whenever you receive a recommendation, visit the pair page on techpaisa.com. For example, in this case, visit NMDC-HINDALCO page.
How to calculate divergence
When doing pairs trading, you should understand what divergence is. (Read our earlier tutorial on pairs trading.) Simply put, divergence is a function of stock prices of constituent stocks in pair. In the above case, divergence is calculated using the folloing formula:
[hindalco_price - (0.8 * nmdc_price) - mean_error]/standard_error
Mean error and standard error are available on pair page.
Here is an explanation of terms:
- Time frame is 3 months which means divergence is tracked over a period of 3 months.
- Entry threshold 1.5 means that take positions when divergence is close to 1.5 (or -1.5) and current divergence specifies the exact divergence at which recommendation was given.
- Target divergence is 0 and stop loss divergence is -2.5.
- For this trade, it doesn't make sense to recommend target prices and stop loss prices as we are dealing with a function of two prices. We suggest that on the pairs page, you follow real time divergence regularly and when the real time divergence hits target divergence or stop loss divergence (stated above for this pair), exit positions.
Other things to keep in mind:
- Take positions around the above prices. When you will do trades, you will be trading in future contracts of above stocks/indices, so the prices you get will be different from above because future contracts trade at certain premium/discount.
- Hold positions for a maximum of 40 trading days (in this example). This is calculated using half life of pair. Again, since you will be trading future contracts which have an expiry date, so when entering the trade, make sure expiry day is beyond the expected duration of trade which we have stated here.
- Maximum number of trading days is specified in each recommendations.
Hope this article clears some doubts about the terms used in recommendations. If there is any doubt, feel free to mail us at firstname.lastname@example.org
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