How many pairs do I need on Watchlist to generate a well-diversified portfolio of pairs in trade?
QUESTION: During the course it is stated that only around 30% of pair trade signals actually meet the criteria for a trade. Working on the basis of a target 20 position portfolio at capacity, I would want around 60 pair trade signals per month. From your experience to achieve 60 trade alerts per month how many high quality pairs would be needed to be maintained in the watchlist ? Assuming the watchlist is maintained with high quality pairs, is there a typical (ball park) ratio for monthly trade alerts to number of pairs in the watch list?
ANSWER: DEPENDS ON YOUR SETTINGS. OBVIOUSLY THE WIDER THE ENTRY STRETCH, THE FEWER THE SIGNALS. A 2.0 ENTRY STRETCH WILL GENERATE A LOT MORE SIGNALS. YOU CAN SENSITIZE THIS A BIT BY RUNNING BACKTESTS ON THE SAME PAIR AT DIFFERENT ENTRY AND EXIT STRETCHES. WE LIKE TO TRADE AT A 2.5 - 2.7 ENTRY STRETCH BUT UP TO YOU.
ALSO, THE LOOKBACK DAYS WILL DETERMINE THE NUMBER OF SIGNALS OVER A GIVEN PERIOD AS WELL AS TRADE DURATION. IF YOU USE A 21 DAY LOOKBACK FOR RATIO, SD, STRETCH ETC. YOU WILL GENERATE MANY MORE SIGNALS IN A YEAR THAN IF YOU USE A 200 DAY LOOKBACK.
AS AN EXAMPLE, USING A 63 DAY LOOKBACK WE LIKE TO SEE PAIRS WITH 7+ TRADES OVER 3 YEARS. LET'S SAY 3 PER YEAR ON AVERAGE. THAT MEANS IT MAY ONLY GENERATE 1 GOOD TRADE SETUP PER YEAR. SO YOU WOULD NEED 20 TRADES X 12 MONTHS = 240 PAIRS FOR THAT PORTFOLIO OF 20 TRADES. BUT WE FIND WE ARE TRADING BETWEEN 5 AND 15 POSITIONS MOST TIMES, WITH A MAX AROUND 25. SO FOR 10-15 ON AVERAGE YOU WOULD NEED 120-180 PAIRS ON WATCHLIST.