Long Short Signal

Looking for stock market safety and opportunity? Long Short Signal (LSS) provides both.

This chart shows LSS results from 1994 to July 2008. $1,000 invested grew to $23,292. Subtracting the original investment, that's a gain of $22,292 . A bank would have to pay 24% interest to earn the same amount while invested every day for 14.57 years. However, Long Short Signal only held investments 51.8% of the time or 7.54 years. A bank would have to pay 52% interest to earn the same amount in 7.54 years.

Long Short Signal (LSS) maintains a database of JDS UNIPHASE (NasdaqGS: JDSU) and NORTEL NTWKS (NYSE: NT). These stocks are dogs that you would not normally buy but they serve an important purpose because their correlation coefficient is greater than .97 (1993-2008). (see the chart to the right showing JDSU vs NT) The program watches the ratio of (JDSU Price)/(NT Price) and when that ratio gets too low or too high, it generates a signal to buy or sell the ratio short. If the ratio returns to normal, LSS generates a SIGNAL to close positions resulting in a profit. If the ratio moves sufficiently in the wrong direction, a signal is generated to close positions resulting in a loss. Buying the ratio means buying JDSU and shorting NT. The program also maintains a simple book-keeping system. When there is a signal to open positions, the program indicates how many shares to buy or sell short. For example, the image below shows a cut-out of a typical signal (Sell the ratio to open) and BROKER ORDERS to sell short 9,154 shares of JDSU and buy 18,370 shares of NT. The number of shares depends on the value of the account.

A ratio that is too low or too high implies a comparison to a normal value. The normal value is an estimation of recent values of the ratio. The normal value could be a moving average of the ratio. A moving average assigns equal weights to each member of the average but a digital filter assigns less weight to older members and more weight to newer members. This program uses a digital low pass electric filter to determine a normal ratio. The ratio is treated as a digital electric wave or signal. The wave or signal is passed through the low pass filter. The filter attenuates short term spikes (high frequencies) but it passes signal changes that occur slowly. Therefore, the normal level cannot be affected by sudden spikes of the ratio but it will follow slow moving ratio changes. A ratio that spikes and remains high (or low) has a low frequency component and the normal level will follow with some delay.

In order to generate buy and sell signals, there has to be a threshold for deviation of the ratio from the normal (filtered) ratio. The threshold level and the filter design parameters were optimized to maximize account value over a 14 year period. The average ratio is expected to be somewhat constant because JDSU is an equipment supplier to NT. Also, JDSU and NT have a correlation coefficient of at least .97 over the last 14 years. The ratio is somewhat constant because JDSU and NT tend to rise and fall together. A signal to open a position always divides the account's cash into 2 equal amounts. One amount is used to go long in one stock while an equal amount is used to short the other stock. You end up with a long position and a short position of equal values. There is some safety in doing this.

1. Losses on one side are offset by profits on the other side. .97 correlation (for 14 years) indicates both stocks will tend to move in the same direction. Correlation in the short term is greatly reduced. This introduces risk but also provides opportunity. The long term correlation provides a bias that acts in our favor. Stocks with near perfect correlation such as gold stocks do not have as much risk but they do not have nearly as much opportunity for gains.

2. There is a limit to what can be lost on any position and it is small as long as the market does not move too fast. When an investment is made, LSS stores the ratio and the filtered ratio. The DIFFERENCE between the RATIO and the FILTERED RATIO is also stored. The open positions are held until the ratio changes by the amount equal to the stored DIFFERENCE resulting in a gain or a loss. A gain is realized when the ratio returns to the stored filtered ratio. A loss is realized when the ratio moves in the wrong direction and by an amount exceeding the stored deviation. This means that potential gains and losses are roughly equal. The amount that can be gained is about equal to the amount that can be lost. LSS looks at daily prices. If a price changes suddenly and sharply (from one day to the next), then the amount at risk will be unusually large because the ratio can jump way past the threshold that generates a SIGNAL. The signal is still generated but the program wants to generate a signal as soon as a threshold is passed.

3. Sometimes financial storms seem to drive the market crazy. The program USUALLY prevents a sting of consecutive losses by refusing to generate signals that would open new positions for 5 days following any loss. The digital filter can usually adjust to the new conditions during this time. The market has had unusual volatility following 25 September 2008. This excessive volatility can stress the digital filter and signal thresholds since the filter was optimized for less volatile conditions (1993-2008). Conditions will eventually settle down. Until then, preservation of capital is king.

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