Directional market bets can be very tricky. Many unpredictable factors can impact the performance of world equity markets which can make the “investment” process seem much more like a “betting” process. For this reason, I usually play in more predictable arenas: mean reverting market risks such as volatility, interest rates, and currencies. The other way to limit your directional risk and increase your ability to make educated investments is to enter into “pairs trades”. Pairs trading generally refers to market neutral trading in which you go long stock X and short stock Y. You enter this trade because you believe that stock X is going to outperform stock Y. This trade mitigates a lot of your risk, because if the markets go down for some unforeseen reason you will lose on your long position in X but gain on your short position in Y as all markets decline.
Generally, the closer the relationship between the two investment that you place in a pairs trade, the lower your overall risk. Earlier this year I entered into a pairs trade in which I shorted Wells Fargo and went long US Bank under the belief that US Bank as an investment was getting thrown out with bathwater just because no one seemed to want to own bank stocks. Going long US Bank and shorting KBE (Banking ETF) is far less risky than going long US Bank and short the S&P 500 because the S&P 500 can move very differently than the banking sector stocks. This difference in movement is called “basis risk”. It is important to understand the basis risk so you fully comprehend the hidden risks of a so-called “market neutral” trade.
As we head into the new year I would like to propose a longer-term pairs trade (with a decent amount of basis risk) that I believe makes sense from an economic and fundamental basis. The idea is to go long emerging market stocks (EEM) and short the S&P 500 (SPY). There are a few reasons that I like this trade:
- The dollar has rallied from its lows as default of Dubai and downgrade of Greece has caused a flight to quality and a short cover on the dollar. The dollar will continue to fall over the longer term and buying emerging market currency exposure while shorting dollar exposure is a good way of capturing that.
- The new global growth engine is overseas and a rebound in the global economy means a spark of economic fire in asian countries such as China, South Korea, & Taiwan.
- Implied volatility for the emerging markets seems relatively cheap versus implied volatility for the United States.
All but the 3rd point might seem like simple reasons. The third is based upon the way implied volatility on the options is trading versus realized volatility on the underlying.
The gap between historical volatility and implied volatility for emerging markets is negligible
The gap between implied volatility and realized volatility for the S&P 500 is still significant - Good for option sellers
With this as the investment backdrop, it is my suggestion to buy 2-3 EEM at the money call options for every written at the money call option on the S&P 500. The tenor of this trade should be 6 months or longer, so look at June 2010 call options or options with expirations further out. This allows the trade time to play out while reducing your concern over intra-month basis risk. I believe that the risk to this trade is low, with the maximum loss only occurring if the S&P 500 rallies strongly while emerging markets are stagnant or declining. I find that particular outcome a low probability event. On the flip side, this trade gives you long exposure to a strongly rebounding global market while limiting the amount of money that you would lose if the global economy sputters.
Disclosure: Short S&P 500, Long EEM
