Long Short Signal (LSS) provides both. LSS is software that generates automated buy and sell signals with an impressive record of back-tested performance. LSS signals go long on stock A and short on highly correlated stock B when their ratio is temporarily distorted. The average rate of return has been 52% per year for the actual time cash was invested.
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 maintains a database of JDS Uniphase (NasdaqGS: JDSU) and NORTEL Networks (NYSE: NT). Both JDSU and NT are dogs that you would not normally buy but they serve an important purpose because their correlation coefficient is greater than .97 (1993-2008). The program watches the ratio of JDSU/NT 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 it generates a signal to close positions resulting in a profit.
Buying the ratio means buying JDSU and shorting NT. When there is a signal to open positions, the program indicates how many shares to buy or sell short. For example, this signal indicates "Sell the ratio to open" by selling short 9,154 shares of JDSU and buying 18,370 shares of NT.
If the ratio is too low or too high it 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 jumps 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, they are highly correlated and they tend to rise and fall together.
The software maintains a simple book-keeping system that keeps tract of all trading. 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 because the stocks are correlated and tend to move in the same direction.
1. Losses on one side (long or short) are offset by profits on the other side. .97 correlation (for 14 years) indicates both stocks will tend to move in the same direction.
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 notes the ratio and the filtered ratio. These values are stored. LSS calculates the deviation (difference) and it is also stored. The open positions are held until the ratio changes by the amount equal to the stored deviation resu