Spread Trading

Jennifer Galperin

Michael Bigger
 Michael Bigger
Michael Bigger is a trader. In 1992, Michael joined Citibank as head
trader of U.S. single-stock derivatives, where he managed a $5
billion portfolio of equity derivatives. In 1998, he joined D.E. Shaw
& Co., L.P. to trade the U.S. equity derivatives portfolio.
In 2000, he started the listed equity options business by
establishing KBC Financial Products as one of the three initial
market-makers of the International Securities Exchange.
In December 2001, Michael left KBC to start his trading firm Bigger
Capital.
Michael received a BS in Physics from the University of Quebec in
Montral in 1986 and an MBA from York University in Toronto in
1991.
As a private investor in start-up companies, Michael was among a
group of investors who sold Innovative Fibers to Alcatel for $175
million in July 2000.
 Professor Campbell
The ones in this class that will make a lot of
money in capital markets during the next decade
will be the ones that will have the ability to sit
down at a desk with a phone and a computer
and make things happen on their own with very
little guidance and other resources. If they can
make money doing this, they will make a lot of
money.
 Emerging Tools
Aris David via Twitter
This class via our blog
Listening to Customers of a value investment
Amazon Cloud
Media Platform
 Jennifer Galperin
Jennifer is a quantitative trader and a
programmer with over 10 years of experience in
finance.

Prior to trading for Bachelier, she sold and traded

equity options for JPMorgan from 2004 to 2008
and for Goldman Sachs from 2001 to 2004.

Jennifer received a BS in chemical engineering

from MIT in 2001.
 Risks of Trading Positions
1. Market Risk
2. Sector Risk
3. Stock-Specific Risks
 Market Risk: Long AAPL
AAPL SPY

9% 10%

Outperformance: 1%

You lose 9%
 Hedge Market Risk

Buy AAPL, hedge by selling SPY

AAPL SPY

9% 10%

Outperformance: 1%

You make 1%
Statistical Arbitrage
Spread Trading
 Spread Trading Example
26 65
Exit
25

Sell
24 60

23

22 55

21
CMS

20 Buy 50 DTE

19

18 45

17

16 40
 Constructing a Spread

Spread = Blue Ratio * Red

Long Spread -> Long Blue, Short Red

Short Spread -> Short Blue, Long Red
 Spread Trading
Sell
5

CMS-DTE
0

-1

-2
Exit
-3

-4

-5
 Mean Reversion Spring Analogy
F = -kx
Diverge
from Mean
Stock B Spread Level
Stock A

Revert to
Mean
Stock B Spread Level
Stock A
Cointegration
 Cointegration Calculation
Step 1: Estimate Beta
Least-squares analysis on this equation:

Price of Price of
Stock A Stock B
Beta Error
Term
Solve for Beta that minimizes epsilon
Spread = Y B*X
 Cointegration Calculation
Step 2: Determine Stationarity
ADF Test on this equation:

Change in Test
Spread Parameter

Drift

Null Hypothesis: =0
Alternative Hypothesis: <0
Cointegration is Confidence Level that the null can be rejected
 Evaluating Candidates
1. Cointegration
2. Deviation from Mean (Z-score)
3. Time to Revert (Half-Life)
 Z-Score
Z-score measures the distance from the mean
in standard deviations

-3 -2 -1 0 1 2 3

68% of Observations

95% of Observations

99.7% of Observations
 Half-Life: Theoretical Chart

2.5
Spread Level (Zscores)

1.5

0.5

0
0 10 20 30 40 50 60
Time

1 HL
2 HL
Earnings
Intrinsic Value Energy
Value Investing: CROX
 CROX: Value Investing
Global marketer of comfortable iconic clogs
Gigantic opportunity:
wholesale
Internet
Amazon.coms shoe best-sellers list
Earning Power > $1
Value Investing: CROX
The Art of Quantitative Trading
 Visit our Website:
www.biggercapital.com
Search for Harvard

Email us:
jengalperin@gmail.com
biggercapital@gmail.com
Questions?