Stocks & Commodities V. 23:8 (21): Q&A by Don Bright
SINCE YOU ASKED
Confused about some aspect of trading? Professional trader Don Bright of Bright Trading (www.stocktrading.com), an equity trading corporation, answers a few of your questions. To submit a question, post your question to our website at http://
Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
MINIMIZING RISK IN PAIRS TRADING
When selecting a portfolio of pairs to minimize market risk, what tools do you use to minimize or diversify away the specific risk? Do you use any aspects from the capital asset pricing model (CAPM) or arbitrage pricing theory (APT)? —Alex
Excellent question. Since correlated pairs trading has been much more lucrative to those who do their homework, we have done our best to cover most of
the bases when determining which specific pairs (of stocks) to trade. The CAPM comes into play, almost inadvertently, since we use systematic risk (beta) and
specific risk (valuations such as price-to-book) in our analysis. The alternative pricing method of arbitrage pricing theory comes into play more along the lines of our historical data and spread ranges. As in most working strategies, we cannot limit ourselves to a few criteria.