Trading Lesson: How Pairs Traders Look for Deviations in ETFs, Equities

08/28/2018 3:30 pm EST

Focus: STRATEGIES

A.J. Monte, CMT

Chief Market Strategist, The Market Guys, Inc.

Exchange traded funds have also become popular with traders who’ve added pairs trading to their playbook. Pairs trading typically involves trading two highly correlated assets, writes AJ Monte CMT Tuesday.

Exchange-traded funds also known as ETFs are similar to mutual funds in that they allow you to diversify your investment dollars within a basket of stocks. The main difference between mutual funds and exchange-traded funds is that ETFs trade on exchanges and can be bought and sold during market hours.

Mutual funds, however, are traded at the end of the day, after their net asset values (NAVs) are calculated. The NAV is simply the formal term for the total value of the basket. If you place an order to buy a mutual fund in the morning, your order won’t be completed until after the trading day ends.

One of the most commonly traded ETFs is the SPDR Dow Jones Industrial Average ETF, which trades under the ticker symbol DIA. The Diamonds as they are known, trade like a stock and represent roughly 1/100 of the value of the Dow Jones Industrial Average (DJIA). The DJIA is an index which tracks the top 30 stocks which are believed to present the strongest representation of the U.S. economy.

ETFs became available in 1993 as a cross between stocks and mutual funds. Not only did they help investors improve their portfolio efficiency, they also lowered investment costs as compared to mutual funds, which had higher fees.

Mutual funds are actively managed by a team of investment managers, therefore most funds charge investors fees to own them. Since 2000 the average annual mutual-fund fee has fallen by more than a third. For stocks that track a stock index, the average fee is now less than 0.1% but, in my opinion, even that is too high.

While the diversification offered through a basket of stocks, found within an ETF, appealed to investors, traders also saw a benefit from trading the ETFs. Many exchange-traded funds offer option contracts liquid enough for the option traders as well. In addition to this, there are contra-funds that are inversely related to the markets, so traders can quickly shift from a long position to a short position as quickly as they can type in a symbol for their favorite bearish ETF.

ETFs have evolved quite a bit since the early nineties, and now offer a wide variety of opportunities for investors and traders alike.  

For the traders who have a high-risk tolerance, there are leveraged ETFs that magnify the price swings of a particular sector by two or three times that of the underlying market.

Exchange traded funds have also become popular with traders who’ve added pairs trading to their playbook. Pairs trading typically involves trading two highly correlated assets. For example, the Dow Jones Industrial Average and the S&P 500 indexes move in sync most of the time, which results in a high correlation between these markets.

Pairs traders look for deviations in this relationship and then attempt to profit from very wide divergences between the two. If the Dow moves lower while the S&P 500 (SPX) rallies higher, the trader will take a short position in the S&P while taking a simultaneous long position in the Dow. Ultimately, the goal is to unwind the position when the two markets snap back to their respective moving averages.

Some pairs traders will even look to single out one of the major holdings within a particular ETF in an effort to exploit the divergence there. For instance, Amgen (AMGN) makes up almost 10% of the holdings for the popular Biotech ETF (BBH). Let’s say Amgen shocks the market with a positive earnings report and the stock gaps up to where the indicators are now registering an over-bought condition.

Equity traders and option traders might take a short position in AMGN but go long on BBH. When the two come back in line, the traders will unwind the position for a profit.

There is a lot more to this strategy, so before you decide to jump into pairs trading, do yourself a favor and plug into one of my webinars, or reach out to me via The Market Guys website so I can give you more of the details.

My point in bringing this strategy up is to expand your horizons so you are not just locked into a buy and hold strategy for the rest of your life. Many investors and traders are interested in learning about creative ways to profit from the market without having to take on a lot more risk.

ETFs, traded within conservative strategies such as these, don’t require you having to a necessarily adjust your risk tolerance to a level which makes you uncomfortable.

Happy Trading.

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