How To Create A Micro Futures Pairs Trade | Pairs Trading Strategy

How To Create A Micro Futures Pairs Trade

 

This article on Futures Pairs Trading is the opinion of Optimus Futures.

Futures Pairs Trading

When someone asks you about futures trading strategies, what comes to mind?

For most of us, two things immediately come to mind: directional and hedging.

But what if we told you there was a third way…a way to use math and probabilities to your advantage?

Sounds interesting, right?

Let us introduce you to futures pairs trading.

You’ll often hear that this type of strategy is for ‘advanced traders only.’ Nothing could be further from the truth.

In fact, we’ll explain not only what it is, but how to do it with as little risk as possible, using one of our favorite instruments, micro futures.

What Is Pairs Trading

People often think of trading as a directional bet.

“I bought E-Mini S&P futures expecting them to go higher.”

And there’s nothing wrong with that approach.

But it relies on you finding an edge within the charts or exploiting some arbitration opportunity buried in order flow.

Pairs trading takes an entirely different approach.

And believe it or not, it can be done (potentially) entirely without charts!

Pairs trading is the simple act of buying one asset and selling another.

Your goal is to profit from the relative over-performance of the product you buy and/or under-performance of the one you sell.

Take a look at the following charts of the Micro E-Mini S&P 500 (MES) futures (top) and the Micro E-Mini Nasdaq 100 (MNQ) futures (bottom).

MES and MNQ

Generally speaking, these two indexes like to trade together.

As noted by the white arrows, you can see how they form lows at roughly the same time.

But every once in a while, one moves further in one direction, leaving a bit of a gap. The blue arrows highlight such an instance.

Here, the MNQ bounced off its lows to top out just shy of the high of the day.

On the other hand, the MES barely covered half its drop.

A pairs trader could take this to mean that if these two assets normally trade close to one another, the MES should outperform the MNQ.

So, they could buy the MES and sell the MNQ, hoping they revert back to the average.

If you entered this trade roughly near the blue arrows and closed out around the second white arrow, you would have made: $330 – $160 = $170.

What Are Micro Futures

Most retail traders get hung up on the amount of money they risk, which is a pressing concern.

If you took that same trade above with the E-Mini contracts, your total profit would be $1,700.

But you could have also lost just as much, if not more.

With a large enough account, a $3,000 loss might make sense. For others, $300 is more in their ballpark.

That’s why micro futures are so crucial to the success of retail traders.

Micro futures have the same capital efficiency as standard contracts but are 1/10th the size.

So, while each tick in the E-mini S&P 500 futures (ES) is worth $12.50, the micro version is only $1.25 per tick.

Micro futures provide all the same benefits as standard futures:

  • Trade continuously from 7:00 PM EST on Sunday to 5:00 PM EST on Friday with a one-hour break from 5:00 PM – 6:00 PM EST each day.
  • Available in multiple instruments, including equity indexes, currencies, metals, commodities, treasury yields, and even Bitcoin.
  • Aren’t subject to pattern day trading rules
However, micro-futures tend to have less liquidity and wider spreads than their standard counterparts, especially in the overnight sessions.

And, if you scalp for a few ticks here and there, you’ll find that your profits relative to commissions won’t be as lucrative.

Understanding Mean Reversion

Pairs trading relies heavily on mean reversion or the tendency for price movement to head towards the averages over time.

The S&P 500 volatility index, known as the VIX, is a great example.

Historically, the VIX trades between 15-18. Rarely does it trade near 10 or above 50. So, while it may not immediately revert to the mean the next day, given enough time, it always has.

Pairs traders rely on the same concept to turn a profit. They expect that correlations continue to hold and that if one of two correlated assets under or over performs, that eventually, the opposite will occur as one ‘catches up’ with the other.

Understanding Correlation & Volatility Adjusted Notional Value

Two key concepts in pairs trading are correlation and notional value.

Correlation is the measure of how closely two assets move together using a range of -1 to +1.

  • +1 = The two variables move together exactly in tandem
  • -1 = The two variables move exactly in the opposite direction in tandem
  • 0 = There is no relationship between the two variables
Think of rain and clouds. The two often appear together, but not 100% of the time.

We might measure their correlation as +0.72.

On the flip side, think of sun and rain. Those two tend to happen at opposite times, but not always. Their correlation might be -0.80.

Correlation tells us how well things move together. But it doesn’t tell us the size of those moves.

For example, the S&P 500 and Nasdaq 100 often move up and down together. But, the Nasdaq 100 tends to move more in percentage terms.

To account for the difference, we look to volatility-adjusted notional value.

Volatility-adjusted notional value sounds complicated, but the math is pretty simple.

We look at the market value of what the futures contract controls and adjust it based on implied volatility.

Futures Pairs Trading Example

  • The Micro S&P 500 contract controls $5 x S&P 500 Index =  $4,514 x $5 = $22,570 of notional value.
  • The Micro Nasdaq 100 contract controls $2 x Nasdaq 100 Index = $15,286 x $2 = $30,572 of notional value.
At face value, we can see that the Nasdaq micro contract controls a third more notional value than the S&P 500 micro.

Now, let’s adjust for volatility using the 30-day implied volatility

  • Micro S&P 500 = $22,570 x 17.9% = $4,040
  • The Micro Nasdaq 100 = $30,572 x 19.6% = $5,992
Adjusting for volatility, we now see that the Nasdaq Micro controls nearly 50% more notional value than the S&P 500 Micro, or in ratio terms 3:2.

To get a close pairs trade, we would want to use 3 contracts of the micro Nasdaq 100 and 2 contracts of the micro S&P 500.

3 Keys To Futures Pairs Trading Strategy

Like most styles, success in pairs trading comes down to three key points:

  1. Risk management – Know how much you can potentially lose or profit off each trade. In conjunction with your probability of success, you can calculate the average expected value for each setup.
  2. Defined entry & exit – You can’t determine your risk without knowing where you plan to enter or exit a trade. With pairs trading, you should consider the spread between the notional value of the futures contracts. You want to see the notional value between the two collapses to turn a profit.
  3. Position sizing – Adding to our discussion about notional value, position sizing is critical to pairs trading. Selecting the right number of contracts on each side determines whether you are doing a neutral pairs trade or have any bias.

Ways To Find Setups

Pairs trading relies on finding temporary breaks in correlation. Here are two ideas to get you started:

  • Events – During important events such as data releases, market futures will often dislocate as traders try to price new information. Sometimes this can lead to permanent shifts in the relative notional value of two correlated assets. However, it also creates excess volatility, which can be used to structure mean reversion trades.
  • Statistical Outliers – Statistical outliers look for moves that fall outside the normal range Bollinger Bands are a great example. This indicator looks at the standard deviation (usually 2x) of the average price (usually closing) for a given set of periods (usually 20-21). This is then plotted into boundaries that identify where an asset is relative to these statistical outliers. You can look for assets near or over their Bollinger Bands and then search correlated assets that haven’t made such powerful moves.

Using More Than Two Assets

Once you add in more than two assets, you must consider things at a portfolio level.

In this higher-level view, you’re looking at the aggregate correlation of the various assets relative to one underlying asset, such as the S&P 500. A commonly used metric is known as Beta weighting. This measure attempts to account for both correlation and volatility.

From there, you look at your weighted directional bias for each asset, only going over or underweight where you expect under or over performance.

Start Trading Today

Micro futures trading starts with as little as $100 and can open up a world of opportunities.

It’s normal to be hesitant if you’ve never tried futures before.

That’s why Optimus Futures provides an array of guides and educational materials to help you get started.

Plus, our expert customer service can help walk you through some of the basics and answer all your questions.

Trading futures and options involve substantial risk of loss and are not suitable for all investors. Past performance is not necessarily indicative of future results.

Start the discussion at community.optimusfutures.com