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Brokerage Suitable for Pairs Trading
Old 10-07-2010, 02:31 PM   #1
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Brokerage Suitable for Pairs Trading

After running R simulations for a few months, I finally opened an S corp and deposited some money with Fidelity. However, much to my dismay, the pairs I am interested in trading have no shares available for shorting. When I ran my screen I looked for pairs that had an average daily volume of 100,000 shares or more. Did I not screen for the right criterion, or is Fidelity brokerage just not the right broker for pairs trading?
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Old 10-07-2010, 02:52 PM   #2
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After running R simulations for a few months, I finally opened an S corp and deposited some money with Fidelity. However, much to my dismay, the pairs I am interested in trading have no shares available for shorting. When I ran my screen I looked for pairs that had an average daily volume of 100,000 shares or more. Did I not screen for the right criterion, or is Fidelity brokerage just not the right broker for pairs trading?
Can you explain the S-Corp's connection with this maneuver?

Ha
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Old 10-07-2010, 03:06 PM   #3
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When you short as is needed in a pair trade, your liability is unlimited. Hence the need to keep this type of trading in an S corp.
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Old 10-07-2010, 03:17 PM   #4
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When you short as is needed in a pair trade, your liability is unlimited. Hence the need to keep this type of trading in an S corp.
I hope you got experienced legal advice, as it seems highly unlikely that if you should have a blow up that the brokerage would not be able to pierce the corporate wall in about a week. Does a doctor or lawyer escape personal liability because he is incorporated? How about a building owner who personally manages the property, would she escape personal liability? In this case it seems that you are not only a shareholder in the corporation, but also the agent making the trades. I do know of one case where a gyppo logger bought a plot on a land contract with a sole owner (himself) C-Corp. He stripped the timber and defaulted on the note. The landowner took back the land, now missing most of the value. The landowner pierced the corporate veil, but it didn't do him much good as this guy, as is the case with most a-holes of his type, barely owned an extra pair of socks. His equipment was leased, his home rented. The landowner, a retired government worker, got a very helpful stupid lesson. Unfortunately, he died not long afterward and thus was not able to make much use of his new knowledge.

I do not know that your plan would not work, but it sure sets off my late night TV get rich weirdness meter.

Additionally, don't forget that the brokerage will be marking your positions to market, and at the first hint of insufficient margin they will be liquidated, and you will be out of business. For you, likely a fairly benign outcome out of the many available.

One more comment. I would imagine the biggest threat to pairs trading to be something you would never discover running r(s). An unexpected news item, for example a buyout offer, or a huge industrial accident, or rat poison being found in a pill bottle would suffice.

Ha
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Old 10-07-2010, 07:24 PM   #5
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When you short as is needed in a pair trade, your liability is unlimited. Hence the need to keep this type of trading in an S corp.
If that were true, why would your broker allow you to do it? Some entity has to back that liability, and I'm pretty sure the broker isn't that entity. And I doubt that pairs traders have enough political clout to get their own bailout from the US taxpayer.

As haha says - get close to the margin limit and you'll be liquidated. S-Corp or just an individual - you're broke either way.

There was a thread a while back about an 'insane strategy' - it took a long time (a year and half?), but it ended badly.

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Old 10-07-2010, 08:13 PM   #6
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Thanks for the concern, but this is not a get rich quick scheme. The S-Corp is there as a back stop, and the corporate asset is only $20k. It's there in case I fall into a coma after I have entered into a trade and can't be awake to back out the trade if it hit its stop loss limit.

Pairs trading is nothing new, and to stay away from one-time events such as Mark Hurd resigning after being found guilty of filing bogus expense reports, I also stay away from pairs trading individual stocks. You can run the simulations yourself. R is a free statistical package, and I'll even pass you the code for finding co-integration between ETF pairs. Still, you as a human being would have to filter out which pairs actually make economic sense. For instance, I keep finding timber ETFs that co-integrate with financial services ETFs, but I'm not going into those pairs, but if I find an ETF that holds BRIC stocks that co-integrates with an ETF that holds Asia-Pacific ex-Japan, then that may be an interesting pair. Oh, and the upside is not 40% a year. It's at best 12% to 15% a year, enough as a supplemental income and hobby.

My original question still stands. If anyone has had experience with brokerages more suitable for this type of trading, please reply.
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Old 10-07-2010, 08:52 PM   #7
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However, much to my dismay, the pairs I am interested in trading have no shares available for shorting. When I ran my screen I looked for pairs that had an average daily volume of 100,000 shares or more. Did I not screen for the right criterion, or is Fidelity brokerage just not the right broker for pairs trading?
It just means that the shareholders chose not to let their brokers have them available for loaning & shorting.

When I was doing this five years ago Fidelity was pretty good about making shares available, and they're one of the bigger gorillas around for borrowing shares to short. You could call their trading desk to talk about it, but I think enforcement is going to start ramping up on naked shorting and brokerages are going to start making it harder to do.

Yes, your liability is hypothetically unlimited. However the reality is that the brokerage sets the margin (which can be very tight for some stocks), the margin calls are automated, and unless your funding supplement beats the deadline then you'll be automatically sold out long before you get to "unlimited". Their lawyers would laugh at your "S" corp... if the legal profession didn't make so much money from people for setting them up.
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Old 10-07-2010, 09:34 PM   #8
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It's at best 12% to 15% a year, enough as a supplemental income and hobby.
OK, sounds interesting, and probably a little too much work for me to want to deal with at this point, but hopefully you do well with those expectations and enjoy the process.

I'm curious if the simulations show the times one could get called out for margin requirements? If that isn't covered it might give a false reading.

Sorry, can't comment on brokers, but maybe the activity here will draw a few more posters. Good luck and have fun with it.

-ERD50
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