We had started a new pair’s trading model several weeks ago
and started to build positions. The market had been very quiet with little
volatility so we were waiting for a day like Friday to stress-test several
components of the model. Given the rather robust equity sell-off it allowed us
to monitor the positions and get acquainted with the various nuances that
appear in any new investment model.
We suffered losses in the portfolio but we also found the
weak points in our execution. The good news is that ten of the fifteen pair’s
trades that we initiated were net gainers on the day, meaning the long
positions did not fall as much as the short positions. That success rate of 67%
in a market that was down almost 3% on the day is encouraging.
What did not work in our favor was the method of allocation
we placed on each side of the trade, i.e. we were exposed too aggressively to
the downside due to our error in weighting the positions.
We went to work this weekend to figure out what needed
improvement and to put new procedures in place to assure this flaw in the
system was eliminated.
Where We Miscalculated
Going into these trades we were basing our net long/short
exposure on weightings derived from the last six months’ beta between the two
securities in question. We understand now that recent pricing sensitivity has
very little correlation to future pricing sensitivity and the method of beta
calculation that we were using was skewed too far in one direction to be
effective. The chart below shows one example of a pair’s trade that we
initiated last week, long PFF / short SPY.
The red triangle represents the short term average (six
month) beta profile that we used for this specific trade. The blue square is
the long-term average (since 2007) beta profile and the green circle is the long-term
median point within the range of beta between the two instruments.
Using the red triangle as our beta profile we saw on Friday
that PFF was down 1.2% on the day. The SPY was down 2.4% on the day. That left
us with a net loss on the pair’s trade of approximately -0.6%. Had we used the
longer term average beta profile our net loss on the trade would have been
-0.2% on the trade. Had we used the median figure our net gain on the trade
would have been +0.5%.
Our relative performance z-score lets us know when there is
an obscure pricing opportunity, i.e. pricing that resides near those protruding
arrows in the figure above. We trade on
the assumption that those points on the outer boundaries will make their way
back to the center and profit from the spread. By taking such an aggressive
long/short ratio as we did in our current trade we have minimized our profit
scenario to PFF rising much faster than SPY or falling much
less than SPY as opposed to a reasonable mean reversion of the two prices. The
basis of our relative price performance z-score is much more effective using
the median beta weighting.
That happened across the board on Friday. Our long VOO /
short XLK resulted in a net pair’s loss of -0.3% when technology clearly
underperformed the S&P 500. Using the median approach would have resulted
in a gain of +0.2% on the trade for the day. The long PCY / short SPY trade
resulted in a net loss of -0.4% vs. +0.6% using the median method. The long EMB
/ short SPY resulted in a net loss of -0.5% vs. what could’ve been a net gain
of +0.6%. Short XLI / long VOO resulted in a smaller net loss of -0.1% vs. a potential
gain of +0.3%. We were down a net -0.9% in short XLE vs. long VOO but could’ve
net a gain of +0.4%.
The list goes on as most of our pair’s moved in the right
direction for us even though we lost money on most of them.
Corrective Action
We are of the opinion that the recent market weakness seen
Friday has the potential to continue over the next several weeks and months.
This is a call that we have been making for the last few weeks. We took profits
from the Brexit lows in our core portfolio over the last two weeks and
attempted to set up defensive positions as pair’s trades to mitigate suspected
market weakness.
Given our belief of further weakness we are taking the
following corrective actions in our pair’s portfolio.
(1)
We will rebalance our existing pair’s trades to
better reflect the median beta profile we discussed. We anticipate this could
help us recoup a majority of Friday’s losses and at the very least decrease the
volatility that we experienced last week.
(2)
All pair’s trades going forward will be done
using the new trade balancing methodology as discussed.
(3)
Over the next few weeks and months, as our macro
market outlook improves and we start to build positions in our core portfolio
we will use that as an opportunity to peel off the newly inserted shorts used
to rebalance the portfolio. This will allow us to recapture the cost of our
market lesson on Friday.
(4)
Stay vigilant and alert to additional nuances
within our pair’s strategy.
Joseph S. Kalinowski, CFA
Email: joe@squaredconcept.net
Twitter: @jskalinowski
Facebook: https://www.facebook.com/JoeKalinowskiCFA/
Blog: http://squaredconcept.blogspot.com/
Web Site: http://www.squaredconcept.net/
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