Sector ETF Pairs Trade

Entry Logic

• Exact Entry Trigger: Go long the strongest sector ETF and short the weakest sector ETF when the ratio of their prices crosses above its 20-period moving average on a 1-hour chart.
• Confirmation: The stronger sector ETF must be above its 50-day SMA, and the weaker sector ETF must be below its 50-day SMA.
• Timeframe: 1-hour chart for entry, daily chart for trend analysis.
• Location Context: The stronger sector should be breaking out of a recent high, while the weaker sector is breaking down from a recent low.
• Market Condition: A market with clear sector divergence and dispersion.

Exit Logic

• Profit Targets: Exit when the price ratio of the two ETFs reverts to its 20-period moving average.
• Scaling Out: Not typically used in pairs trading.
• Trailing Stop: Not applicable. The exit is based on the ratio reverting to its mean.
• Signal Failure Exit: Exit the pair trade if the ratio moves 2 ATR (14-period on the 1-hour chart) against the entry.
• Opposite Signal Exit: Exit if the ratio crosses below its 20-period moving average.
• Time Expiration: Exit the trade after 10 trading days if the target has not been reached.
• Momentum Loss: Exit if the spread between the two ETFs begins to narrow significantly.

Stop Loss Structure

• Hard Stop: A hard stop is placed on the spread itself, at 2x the 14-period ATR of the ratio.
• Soft Stop: If the correlation between the two sectors breaks down (moves towards 0 or negative).
• Max Dollar Loss: 1.5% of the account value on the combined position.
• Max Percent Loss: 3% loss on the spread.
• Structural Stop: If the stronger sector breaks below its 50-day SMA or the weaker sector breaks above its 50-day SMA.

Risk Management Framework

• Risk Per Trade: 1% of the account on the total pairs trade.
• Maximum Daily Loss Limit: 2% of the account.
• Maximum Weekly Loss Limit: 4% of the account.
• Maximum Drawdown: 12% from peak equity.
• R:R Requirement: Aim for a 2:1 risk-reward ratio based on the expected convergence of the spread.

Position Sizing Model

• Sizing Approach: Dollar-neutral position sizing. The dollar value of the long position should equal the dollar value of the short position.
• Volatility Adjustment: Not directly applied to sizing, but the stop loss is volatility-adjusted.
• Conviction Sizing: Not applicable for this market-neutral strategy.
• Scaling In: Not recommended.
• Scaling Out: Not recommended.

Trade Filtering

• Market Conditions to Avoid: Avoid during low-volatility, highly correlated market environments.
• Specific Setups Required: A clear divergence in performance between two sectors over the past 20 trading days.
• Instruments: Liquid, non-leveraged sector ETFs.
• Time Restrictions: No specific time of day restrictions, but entries are best made during periods of high liquidity.
• Chop/News Avoidance: Avoid entering trades around major sector-specific news events.

Context Framework

• Trend Direction: The strategy is market-neutral, so the overall market trend is less important than the relative trend between the two sectors.
• VWAP Relationship: Not a primary consideration for this strategy.
• Moving Average Relationship: The long side should be above its 50-day SMA, and the short side below its 50-day SMA.
• Range Location: The spread ratio should be at an extreme, far from its mean.
• Higher TF Alignment: The divergence between the sectors should be visible on the weekly chart as well.

Trade Management Rules

• Breakeven: Not applicable in the traditional sense. The position is managed based on the spread.
• Scale Out: Not applicable.
• Add Size: Not applicable.
• Fast vs Slow Moves: The strategy profits from the convergence of the spread, which is typically a slower-moving process.

Time Rules

• Optimal Trading Window: No specific window, but the analysis should be done on a daily or weekly basis.
• Times to Avoid: Illiquid market periods.
• Session Notes: This is a swing trading strategy, not an intraday strategy.

Setup Classification

• A+ Setup: Strong, sustained divergence between two sectors with low correlation.
• A Setup: Clear divergence, but with some correlation between the sectors.
• B Setup: Weaker divergence or higher correlation.
• C Setup: No clear divergence or high correlation.

Market Selection Criteria

• Instruments: Major sector ETFs.
• Volume/Liquidity: High volume and liquidity are essential for both legs of the trade.
• Volatility: The spread itself should have sufficient volatility to offer a reasonable profit potential.

Statistical Edge Metrics

• Expected Win Rate: 55-60%.
• Average Win Size: 1.5x the average loss.
• Average Loss Size: 1x the defined risk.
• Profit Factor: 1.5 - 1.8.
• Expectancy Per Trade: Positive, aiming for > 0.2R per trade.

Failure Conditions

• Market Conditions: Fails when the correlation between the two sectors suddenly increases, or when the divergence reverses.
• Specific Scenarios: A market-wide event that causes all sectors to move in the same direction.

Psychological Rules

• Key Mental Discipline: Requires patience to wait for the spread to converge. Must manage two positions simultaneously.

Advanced Components

• Market Regime Detection: The strategy works best in a market with clear winners and losers, not a market where everything is moving together.
• Volatility/Liquidity Filters: Essential for both legs of the trade.
• Correlation Filters: The two sectors should have a low or negative correlation.
• MTF Alignment: The divergence should be confirmed on multiple timeframes.

Location

• Where Strongest: In markets with clear sector rotation and dispersion.
• Where Weakest: In highly correlated, low-volatility markets.