The Low Risk Pairs Trade on the S&P 500 Passes Its First Test

(This is an excerpt from an article I originally published on Seeking Alpha on January 16, 2014. Click here to read the entire piece.)

On December 1, 2013, I wrote a piece called “A Potentially Low Risk Pairs Trade Opportunity Using The S&P 500” where I used PowerShares S&P 500 Low Volatility (SPLV) and PowerShares S&P 500 High Beta (SPHB) to form a pairs trade against the S&P 500 (SPY). Since then, SPHB has further extended its recent outperformance versus SPLV and SPY. SPHB is up 4.0%. SPLV is exactly even. SPY is up 2.0%.

Even more importantly, the pairs trade has performed exactly as I could have hoped (although I threw in a twist I will explain soon). The following graph shows that the difference between SPY and the optimal linear combination of SPLV and SPHB approached the bottom of its recent range and triggered a trade going long SPHB and SPLV in the ratio 2.57/3.24 respectively versus short 1 SPY as described and calculated in the previous piece. The trigger occurred on December 11, 2013 and in a month’s time, the combination has reverted to flatline, returning a little over 1% in gains. (In good news for the potential sustainability of this pairs trade, my recalibration of the ratio using all of 2013 data produced almost identical parameters.)


Difference Between SPY and the Optimal Linear Combination of SPLV and SPHB
Difference Between SPY and the Optimal Linear Combination of SPLV and SPHB

Source for price data: FreeStockCharts.com

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I am also taking some cues from Joe Duran, CEO of United Capital Financial Advisers who appeared on Nightly Business Report on January 3, 2014 (at 4:00 in the video broadcast). Duran has a bullish forecast for the economy in 2014 but is still on the lookout for a sizeable correction.

{snip}

In this case, I like being positioned in puts on the short side of the pairs trade. The relative protection/profits grow the steeper the correction gets. Timing will be everything of course. {snip}



Be careful out there!

(This is an excerpt from an article I originally published on Seeking Alpha on January 16, 2014. Click here to read the entire piece.)

Full disclosure: long SPLV, SPHB, SSO puts

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