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January 1, 2005

Trading Strategies Made Easy

By Editorial Staff

Smith: Underneath Excel is plumbing. That says: when I change this cell, change that cell and keep track of the formulas and allow me to audit the formulas and what effects what, etc. Plumbing that allows you to plug in add-ins like Bloomberg or custom formulas. And you don't want to write all that stuff. You just want to write your formulas in Excel spreadsheets. Yellowstone lets you do your position tracking, your order tracking, market data interfaces, calculations, currency conversions, and order formation. It asks you whether you are doing constant money or constant units or shares. It does commission calculations. How does the commission effect you? When you are constructing a trading strategy you don't want to have to re-write all this stuff every time.

Traders: Will 4S.Yellowstone work with Excel if necessary?

Smith: Yes. That's a key design feature. We wanted to be able to integrate with Excel because we knew it was ubiquitous. Certainly, you can send data out of Yellowstone into Excel and take stuff in from Excel. But you can also actually write your business logic in an Excel macro.

Traders: Your second product 4S.Klondike helps traders find profitable pairs. Is most of the demand for your technology coming from pairs traders?

Smith: We saw a lot of demand for pairs trading. But we really went into it without any notions. 4S.Yellowstone would do pairs, indices, single instruments. It didn't really matter.

Traders: 4S.Klondike uses statistical analysis to find potential trading pairs?

Smith: Some potential customers knew the pairs they wanted to trade, but they also wanted to investigate non-standard pairs. Someone would trade Air France against Lufthansa, for example. They're both airlines. But what about Air France against General Electric? Does that make any sense?

Traders: The software determines the probability that these pairs will be a good trade?

Smith: It's not really a probability tool. It is looking at correlation, ratio and regression. You can look at the correlation over three different time frames: short term, medium term and long term. For example, find me the pairs that are correlated over the long term, but over the short term their correlation is pretty variable. So when the short-term correlation goes way out of whack, a pairs trader places a bet because he thinks the long term correlation is there.

Traders: OK. Go on.

Smith: Most of our strategies are either mean reversion or momentum. When something is going back to an average or a mean or they find momentum and ride it.

Traders: So, if Lufthansa and Air France generally trade within a few euros of each other and one suddenly moves sharply, the idea is that they will eventually revert to their traditional relationship?

Smith: That's right.

Traders: How have traders traditionally sought out pairs trading opportunities?