Category: Investing Insight

Investing insight to make you a better investor.

The Disruptor’s Dilemma

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On our shark-fin posts earlier (here, here), we saw how even the most entrenched industries are getting disrupted as the cost of innovation plummets. But that is not to say disruption is easy. Incumbents have a number of levers to pull before they fade away. The biggest lever of them all is regulation.

Tesla Motors

Tesla wanted to sell its cars directly to consumers. But this threatens the business model of car dealerships. So New Jersey’s franchise auto dealers association successfully got the state to make a ruling that prohibited Tesla from selling its luxury electric vehicles directly to consumers.

And its not just in New Jersey. Auto dealers around the US have been lobbying their state governments to force Tesla to change its ways. Dealers like the existing system, and they don’t want other automakers to get any ideas.

So while Tesla can cry itself hoarse as to how a direct sales model is beneficial to its customers, it’s plan to disrupt the way in which cars are sold has been effectively stalled.

Read: Shut up and deal

Uber

Uber is a “ride-share” company that allows you to request, ride, and pay for a “taxi” all through your mobile phone. They have mobile apps that connects you with a driver who gets the GPS coordinates of your location. You can then track where the driver is on your mobile and usually, the car arrives within 15 minutes.

The problem is that taxis are tightly regulated and unionized. For example, in New York City, taxi “medallions” are auctioned off once a year and wanna-be taxi drivers pay as much as a million dollars for these rare and wonderful permits that give them the right to operate a taxi and pick up street hails. In fact, this business model is so profitable, that there’s actually a publicly listed firm that finances taxi medallions.

In Chicago, cab drivers are suing the city, arguing that the city is damaging and discriminating against them by refusing to enforce the same stringent regulations it has long imposed on the taxi industry on these newer “de facto taxi services,” which function “in all material respects as taxi companies.”

In France, there are plans to allow only existing taxis to use GPS services like Uber. Spanish taxi drivers are now calling for an Uber ban.

Some critics think that Uber is a race to the bottom, a way of ducking valuable regulations in place to ensure the quality of existing taxi services, slashing working class wages and simultaneously using tax loopholes to dodge paying their fair share into the system.

So while Uber can cry itself hoarse as to how it is bringing efficiency into the public transportation marketplace, its expansion plans are effectively bogged down by street fighting.

Read: Brace yourself for the European Uber war

Outbox

At least Tesla and Uber have huge war chests of venture capital to fight regulatory assaults against their business model. But not all startups are this lucky. Take Outbox for example. They wanted to allow consumers to digitize all of their postal mail so that individuals could get rid of junk mail, keep important things organized and never have to go out to their mailbox again. Customers would opt-in for $5 a month with “Outbox” to have their mail redirected, opened, scanned and available online or through a phone app. Consumers could then click on a particular scanned letter and ask that it be physically delivered, or that certain types of letters not be opened.

But the US Postal Service would have none of it. In the words of the Postmaster General himself: “You mentioned making the service better for our customers; but the American citizens aren’t our customers—about 400 junk mailers are our customers. Your service hurts our ability to serve those customers.”

Outbox decided to shutdown rather than take on the USPS.

Read: Outbox vs. USPS: How the Post Office Killed Digital Mail

Forgiveness vs. Permission

“It’s better to beg for forgiveness than to ask for permission.”

Eric Jackson, who was PayPal’s first marketing director, had this to say in the book The PayPal Wars: “Regulators say, ‘If we don’t know what you are, you must be dangerous, and later on we’ll figure out what we’ll call you.'” In 2002, Louisiana regulators nearly banned PayPal from operating in the state, sending the company a warning that it might be operating there illegally.

Paypal argued for years with officials over whether it was, or wasn’t, an illegal banking operation. Cut to the present, PayPal has licenses wherever it needs state approval and that has become a big part of its competitive advantage. But it had to sell itself to eBay in order to win the war.

Read: Who Killed PayPal?

A cash-strapped startup typically won’t have the patience, expertise or resources to ‘ask permission’ as such. Instead, they calculate that it’s better to move forward with bringing their product to market and deal with the consequences if and when they gain traction (because if they don’t gain traction, no one will come after them and it will all be moot anyway).

For example, in the music business, negotiating content licensing deals with record labels can take months. While the original Napster is one example where begging forgiveness didn’t pay off, there are successful startups that begged forgiveness once they had traction: iMeem, YouTube and MySpace.

Read: Digital Music Startups

Samsung first copied Nokia and then blatantly copied Apple. Four days ago a jury found Samsung guilty of patent infringement and ordered it to pay $290 million. A year ago another jury also ruled in Apple’s favor against Samsung, accessing $1.049 billion in damages. In the meantime, Samsung generated almost $30 billion in annual revenue in its IT & Mobile Communications Division. So that $1 billion and change penalty levied by two juries might be less than 2% of the annual revenue that mobile device sales generate for the company.

Read: The GoldieBlox playbook: Imitate Youtube and Samsung

What should disruptors do?

There’s life before meaningful traction and then there’s the life after. Disruptors can get away with a lot of things before they become a big enough target. But once they do, the biggest mistake is to assume that the competitive response will be through product innovation alone. Existing regulatory frameworks can be used by incumbents to put up a long and expensive fight and can be a significant source of their competitive advantage.

The way out of the dilemma: forget about permission, but start asking for forgiveness soon after you get traction.

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Backtesting a Pair Trading Strategy

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A pairs trading strategy involves answering these questions:

  1. How do you identify “stocks that move together?”
  2. Should they be in the same industry?
  3. How far should they have to diverge before you enter the trade?
  4. When is a position unwound?

We saw how to answer the first two questions: understanding, defining, finding, and investigating pairs.

Trading strategy

We can start with a simple trading strategy: we buy the spread if it is one standard deviation below the average and sell the spread if its is one standard deviation above the average.

To keep things simple, we’ll ignore execution details like lot-size, actual $ p&l, etc… and focus on the viability of the strategy. We calculate p&l in terms of unit-spread, i.e., how many ‘spreads’ of p&l did the strategy create?

For BANKNIFTY vs. ICICIBANK, we simulated the strategy outlined above based on the daily close of the nearest to expiry futures from Jan-2010:

BANKNIFTY - ICICIBANK pair trade backtest 50 2010-01-01 long-short

The top chart is the the spread.
The 2nd is the trade: green implies the strategy went long the spread, red implies short.
The 3rd chart indicates the p&l of that specific trade (in spreads).
The last chart indicates the cumulative p&l (in spreads).
 
The p&l for this strategy over the entire time-period is +69.3189 spreads.

Asymmetric strategy

The idea behind the above strategy is to bet on mean-reversion on both sides. However, if you see closely, the shorts were not nearly as profitable as the longs. You could be better off just going long the spread whenever it hit one standard deviation and staying out of the market when the spread hit the upper band.

BANKNIFTY vs. ICICIBANK, long-only p&l +454.3036:

BANKNIFTY - ICICIBANK pair trade backtest 50 2010-01-01 long only

BANKNIFTY vs. HDFCBANK, long-only p&l +231.5225:

BANKNIFTY - HDFCBANK pair trade backtest 50 2010-01-01 long only

Conclusion

Some caveats:

  1. The signals are intermittent, but you need to keep running the algorithms everyday to capture the alpha. This requires an investment in systems on your part.
  2. The backtest ignores execution risk. For example, the hedge ratio is around 0.09830581 and there’s no way you can trade 1/10th of a contract. So your actual executable spread = 10 ICICIBANK – BANKNIFTY. That’s 11 contacts and it still doesn’t give you precision.

On the plus side:

  1. The backtest doesn’t do any risk management. This would’ve stop-loss’ed most of the bad trades.
  2. There is money to be made on the right pairs.
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The Bank Nifty – ICICI Bank Pair

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We defined the spread between a pair to be:

spread = A – βB

where A and B are prices and β is the first regression coefficient.

The β is also known as the hedge ratio.

Neither β, nor the relationship is “guaranteed” to be stable. Here are the p-values and β of Bank Nifty vs. ICICI Bank nearest to expiry futures, with a 50-day look-back:

BANKNIFTY - ICICIBANK p-value and beta 50

As you can see, the spread has periods of stability and adjustment. And sometimes, the stability is the anomaly.

To be continued…

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Finding Pairs to Trade

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Correlation

When we discussed banks and introduced pair trading, we pointed out that a pairs trading strategy involves answering these questions:

  1. How do you identify “stocks that move together?”
  2. Should they be in the same industry?
  3. How far should they have to diverge before you enter the trade?
  4. When is a position unwound?

Traders new to pair trading often mistake the correlation of prices to be indicative of “similarity”. For example, consider the Bank Nifty, HDFC Bank and ICICI bank. Here’s the chart of the closing price of the nearest to expiration futures contract:

bank-futures-prices

And there are some really tight correlations:

BANKNIFTY HDFCBANK ICICIBANK
BANKNIFTY 1.0000000 0.7419966 0.9462238
HDFCBANK 0.7419966 1.0000000 0.8327847
ICICIBANK 0.9462238 0.8327847 1.0000000

However, this is only part of the story. What we need are pairs who’s price movements are mean reverting. Looking at price correlation alone is not enough.

Spreads

We need the spread between pairs to be “stable”, i.e., mean reverting.

spread = A – βB

where A and B are prices and β is the first regression coefficient.

200-day spreads

Here are the spreads between these pairs using 200-day data for regression:

BANKNIFTY - ICICIBANK Spread 200

BANKNIFTY - HDFCBANK Spread 200

ICICIBANK - HDFCBANK Spread 200

50-day spreads

Here are the spreads between these pairs using 50-day data for regression:

BANKNIFTY - ICICIBANK Spread 50

BANKNIFTY - HDFCBANK Spread 50

ICICIBANK - HDFCBANK Spread 50

Testing for cointegration

You don’t have to visually inspect spreads to see if they are mean-reverting. The most straightforward way of checking if a time-series is co-integrated is to perform a Dickey-Fuller test on it. If the p-value is less than 0.10, then this could be a good pair for trading.

N Pair p-value
300 BANKNIFTY vs. ICICIBANK 0.010000
300 BANKNIFTY vs. HDFCBANK 0.904480
300 ICICIBANK vs. HDFCBANK 0.407347
200 BANKNIFTY vs. ICICIBANK 0.010000
200 BANKNIFTY vs. HDFCBANK 0.472129
200 ICICIBANK vs. HDFCBANK 0.037115
100 BANKNIFTY vs. ICICIBANK 0.223806
100 BANKNIFTY vs. HDFCBANK 0.980776
100 ICICIBANK vs. HDFCBANK 0.670717
50 BANKNIFTY vs. ICICIBANK 0.429057
50 BANKNIFTY vs. HDFCBANK 0.405498
50 ICICIBANK vs. HDFCBANK 0.133357
30 BANKNIFTY vs. ICICIBANK 0.570427
30 BANKNIFTY vs. HDFCBANK 0.057717
30 ICICIBANK vs. HDFCBANK 0.370011

If you are trading futures, then a 200-day fit may not make much sense. The latest 30-day test between BANKNIFTY and HDFCBANK has a surprisingly low p-value of 0.057, indicating that there is a potential trade there.

To be continued…

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Bank Nifty vs. HDFC Bank and ICICI Bank

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We recently discussed linear regression by using it to inspect the relationship between two banking stocks. Lets try and extend that treatment to an index and its predominant constituents.

Bank Nifty

The Bank Nifty is composed of 12 bank stocks with ICICIBANK and HDFCBANK making up 29.27% and 28.26% of the index, respectively. Lets start with the scatterplot of daily log returns of the nearest to expiration futures.

bank-futures

Notice the strong relationship between the index and the banks?

Q-Q Plots

ICICIBANK~HDFCBANK-q-q-plot

BANKNIFTY~ICICIBANK-q-q-plot

BANKNIFTY~HDFCBANK-q-q-plot

Index vs. Banks have a predominantly Gaussian distribution. HDFC vs. ICICI – not so much.

Pairs trading

With this knowledge in hand, can we trade pairs made out of these three? The rules for pairs trading is fairly straightforward:

  1. find stocks that move together
  2. take a long–short position when they diverge and unwind on convergence

The execution of a pairs trading strategy involves answering these questions:

  1. How do you identify “stocks that move together?”
  2. Should they be in the same industry?
  3. How far should they have to diverge before you enter the trade?
  4. When is a position unwound?

Bank Nifty, HDFC Bank and ICICI Bank certainly fit the criteria.

Co-integrated prices

If the long and short components fluctuate due to common factors, then the prices of the component portfolios would be co-integrated and the pairs trading strategy should work.

If we have two non-stationary time series X and Y that become stationary when differenced (these are called integrated of order one series, or I(1) series) such that some linear combination of X and Y is stationary (aka, I(0)), then we say that X and Y are cointegrated. In other words, while neither X nor Y alone hovers around a constant value, some combination of them does, so we can think of cointegration as describing a particular kind of long-run equilibrium relationship.

For a light introduction to co-integration, read this post on Quora.

To be continued…

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