(This is an excerpt from an article I originally published on Seeking Alpha on December 1, 2013. Click here to read the entire piece.)
I recently read a Seeking Alpha article titled “Today’s Stock Rally Is Full Of It” by contributor Eric Parnell. It first caught my eye because it included two relatively new ETFs I had not yet heard of: PowerShares S&P 500 Low Volatility (SPLV) and PowerShares S&P 500 High Beta (SPHB). {snip}
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Source: FreeStockCharts.com
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Theoretically, if the middle 300 stocks were perfectly harmonized between low volatility and high beta, then some linear combination of the prices for SPLV and SPHB should consistently equal the price of SPY. However, this relationship has not held over time, thus generating the pairs trade opportunity.
Here is the equation to consider: SPY = a*SPLV + b*SPHB where a and b are numeric values (coefficients). {snip}
Source for price data: Yahoo Finance
Notice the near-cyclical behavior of the error rate. There is an almost 2-month cycle between troughs which means that “eventually” the error crosses zero and taps the upper and lower bounds. This structure produces the specific and quantifiable pairs trade opportunity. {snip}
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Be careful out there!
(This is an excerpt from an article I originally published on Seeking Alpha on December 1, 2013. Click here to read the entire piece.)
Full disclosure: no positions (but likely to initiate this trade in the coming week or so)